What is the ETF Bubble?

 The ETF bubble refers to concerns about the rapid growth and potential overvaluation of ETFs, which could have significant consequences for financial markets and the broader economy. The main argument boils down to the idea that passive investing and ETFs can make more established companies overvalued while leaving behind smaller companies. In essence, passive investing via ETFs dislocates pricing from fundamentals, causing pricing inefficiencies, reducing differentiation of “good” and “bad” companies within an index, and inflates stock valuation in an unhealthy and potentially catastrophic manner.

Potential Consequences of the ETF Bubble

• Increase of Overvalued Stocks Within ETFs & Major Sell-Offs
  • As more money is invested passively, and especially into ETFs, stocks can slowly become overvalued. As a result, this could create far greater implications on the global economy. If the ETF bubble were to “pop” due to an external event, scared investors could be pressured to sell-off instantly, causing the market to follow.
• Lack of Price Discovery
  • A popular notion of ETFs is that they severely reduce risk in a portfolio. However, the dangers of this notion lead to a lack of price discovery. Since stocks are just being placed into the ETF basket, there is no double checking to unveil the true stock prices. Instead of performing a technical or fundamental analysis, investors are simply pouring money into ETFs hoping for the best, eliminating the point of price discovery.
• Issue of Liquidity in ETFs
  • ETFs are sometimes criticized for providing an “illusion of liquidity.” This means that while ETFs may appear to be highly liquid, their actual liquidity is dependent on the liquidity of the underlying assets. During periods of market stress, the liquidity of these underlying assets can dry up, making it difficult to trade ETF shares without significant price impacts

Counterarguments to the ETF Bubble

While there are many potential consequences of the ETF bubble, many investors discredit the existence of one. Here are a few counterarguments to the ETF bubble hypothesis:

• Passive Investments Outperform Active Funds
  • Many investors argue that the increase of investments into ETFs is beneficial rather than harmful for investors. Many passive investments are starting to outperform some actively managed funds.
• ETFs as Tools Not Assets
  • Some investors argue that ETFs themselves cannot lead to a bubble as they are merely investment tools that simply reflect the underlying assets.
• Diversification and Varying ETF Types
  • ETFs offer diversification and low-cost exposure to various asset classes, which can be beneficial for investors. In addition, there are several types of ETFs, some more susceptible to bubble-like behavior than others.

Ultimately, we at Rich to Wealthy believe that the rise of ETF and passive investing is likely to lead to significantly more good than harm. Research out of the University of Pennsylvania agrees, finding that the growth of passive investing was not responsible for a widespread boost in valuations (although it did decrease the effects of new information on pricing and also increased volatility). So while you should be aware of the potential drawbacks, we will continue to sing the praises of low-cost index funds for the foreseeable future!

https://www.finax.eu/en/blog/are-etfs-a-bubble
https://www.investopedia.com/articles/stocks/10/5-steps-of-a-bubble.asp
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4551509