I listened to a webcast yesterday with the Mauldin Economics team. Jared Dillian, one of the members of said team, talked about bubbles and specifically highlighted ETFs and passive investment strategies.
He made a very interesting point about how ETFs are basically the asset class “you have to own now”, similar to tech stocks at the turn of the century and single-family homes last decade. We all know how those investments turned out.
ETFs are clearly very popular these days with more ETFs available than individual stocks, according to Dillian. While passive investment strategies have their merit and have been outperforming active investment strategies, on average, for quite some time now, a sense of complacency can certainly creep in with a passive investment strategy and the use of ETFs, especially when the market only appears to be going up.
I often wonder what the next downturn will look like and what sectors or asset classes will be most impacted. Investment vehicles are another consideration for biggest loser when contemplating market corrections. Think of what happened to structured investment products like mortgage-backed securities and collateralized debt obligations last cycle. Those vehicles weren’t even available to retail investors for the most part although they were a byproduct of the single-family housing bubble. ETFs, on the other hand, are available to anyone with a brokerage account so the potential for things to get out of hand with ETFs is very realistic. As demand for ETFs increases, new shares are issued. In other words, ETFs can continuously issue shares to meet investor demand. However, ETFs aren’t like individual companies that can buy their stock back when the valuation is attractive. So what happens when the market corrects and all those folks who bought ETFs want to sell at the same time? It likely won’t be pretty.
I’m not making a call but there are certainly elements of herd mentality, complacency and perhaps even irrational exuberance when it comes to ETFs and passive investment strategies. This may all blow over with little to no negative impact but it’s something important to be aware of and to keep an eye on going forward.
DISCLOSURE: I use ETFs and elements of passive investment strategies in managing client portfolios as well as my own portfolio.