by | Feb 22, 2020 | Precious Metals

Exchange-traded funds (ETFs) are rising in popularity, despite legislative efforts to cool the market. According to Bank of America, the ETF market will hit $50 trillion in assets by 2030. That’s a staggering growth trajectory, considering the market only crossed the $4 trillion mark in 2019, and is projected to eclipse $5.3 trillion by the end of this year.

Lately, passive investing has been the preferred option for individual and institutional investors alike. Perhaps for none more than Vanguard, who currently own at least a 5 percent stake in 491 of the 500 stocks contained in the S&P 500. As more investors flock to passive funds, new risks are presented by overcrowding. 

With overcrowding comes the potential for an asset bubble. When the bubble inevitably bursts, so too does the value of the assets that underlie them—not to mention the portfolio values of the investors who’ve put their money behind them. 

Liquid, stable, and efficient markets must avoid asset bubbles. If the ETF market continues to inflate, we may very well find ourselves within one. Fortunately, there are steps investors can take to minimize their exposure to the systemic risk brought on by a ballooning ETF market. 

ETFs 101

ETFs are a basket of stocks that track an index, bond, or commodity. The price of an ETF will reflect the price movement of the underlying index or asset that the ETF is tracking—when the underlying value increases, so too does the ETF, thereby generating a return for the investor. 

As passive investments, ETFs are long holds that benefit from low fees and a lower tax burden over time compared to actively traded investments. While ETFs help investors generate high returns at lower costs, they now represent a massive 45 percent of the entire stock market, up from only 25 percent in the late-2000s. 

The dominance of ETFs has made it difficult for investors to perform the necessary tasks of price discovery and fundamental analysis. For investors to find the true value of an asset, they need to analyze each of them at the security-level rather than a basket of assets. This is becoming increasingly difficult in an opaque market dominated by ETFs. The consequence is that it’s not so easy anymore to spot mispricing and trade individual stocks according to their fundamental value.

Dispelling The Myths

The ETF market, no matter how overinflated, is not a cause of market instability but rather a symptom of it. That ETF trading volume is increasing says nothing of the value of their underlying financial instruments. An uptick in ETF trading does not distort the value of underlying securities or give rise to volatility.

In fact, it’s the other way around. Whatever behavioral biases, distortions in investor sentiment, or bubbles arise in the ETF market are a consequence of distortions in their underlying securities. If investors are bearish on any particular sector of the market, we will see a downturn in trading volume and asset prices regardless of their status as exchange-traded assets. ETFs merely provide a convenient vehicle for investing in a particular sector, industry, or asset class. 

Overall, ETFs still make up a small share of the global equity market (5%) and don’t carry enough sway to precipitate major structural changes in the event of a sell-off. However, given that ETFs now hold more than 11 percent of the US real estate sector and nearly 10 percent of the utility sector, an ETF correction may cause widespread economy-wide distress. 

New Regulations, New Risks

The new Basel III rules have made it more difficult for banks to acquire ETFs. It may well be that these new regulations are enough to turn the tide and usher in a major sell-off or market correction. Gone are the days when banks and institutional investors can man proprietary desks that take away trades from buy-side clients that offload positions. 

With Basel III having entered into law in 2019, proprietary trading, which is when banks or investment firms invest their own cash rather than their client’s funds, is now heavily curtailed if not outright outlawed. What this means for the ETF and passives market is that when the inevitable market correction arrives, it will be difficult for banks and firms to catch its fall. 

Protect Your Wealth

ETFs and other passive investments are in bubble territory, and the new post-Basel III regulatory environment will worsen the effects of its eventual burst. Amid uncertainty in the market, it’s crucial that you take steps to safeguard your investments and diversify your portfolio. 

The overinflation of the ETF market is symptomatic of distorted market valuations and a volatile securities economy. Worse yet, many ETF investors are unaware of the risks to which they’re exposed. Although ETFs were once heralded as a simple method of “buying the market” and diversifying exposure, they might now be the Achille’s heel that tanks their portfolio when the bubble eventually bursts. 

To achieve true diversification, trust blue-chip alternative investments that aren’t tethered to the stock or bond market. Investing in gold and other precious metals can help safeguard your wealth when the stock market ends its record-setting bull run and the ETF market deflates. Plus, right now investors can achieve diversification while also capitalizing on the bullish gold market as the yellow metal fast approaches its 7-year high amid international instability. 

While gold and alternative asset investing provide an excellent hedge against systemic risk in the equities and securities market, you should always first consult with your financial advisor before investing your money.

Liam Hunt

Liam Hunt, M.A., is a financial writer covering global finance, commodities, monetary policy, and millennial investing. His commentary and analysis have been featured in the New York Post, Reader's Digest, Fox Business, Yahoo Finance, and Forbes.