Big Market Players Are Loving ETFs Even as They Fear the Fallout

Large institutions have jacked up their usage of exchange-traded funds since the Covid crash -- even as they fear these investing tools are fueling market volatility.

About a third of institutional traders surveyed by Keefe, Bruyette & Woods said they’re embracing ETFs more in the wake of the March 2020 stock collapse, which sparked a deleveraging wave like no other across the financial system.

Of 40 respondents, 85% said the liquidity of products is their key selling point. Nearly nine in 10 plan to use them to the same degree or more this year.

But despite the full-throated endorsement from the likes of hedge funds and private-equity firms, concerns that ETFs are distorting markets prove remarkably enduring.

Virtually all professional traders said these typically passive products have “a meaningful impact” on share prices and trading volumes -- with 83% saying they’re creating volatility.

Big Market Players Are Loving ETFs Even as They Fear the Fallout

“Institutional investors are increasingly more focused on the impact of ETFs on the underlying equities,” according to the survey published this week.

The likes of Michael Green, chief strategist at Simplify Asset Management, have long warned that passive investing is creating an unsustainable bubble in asset prices. And while it’s notoriously difficult to precisely pinpoint the impact of passive flows on stock prices, academics have found links. For example, a 2014 paper from the National Bureau of Economic Research concluded stocks held by a substantial number of ETFs were more volatile than equities that weren’t.

Defenders point to the fact that the cohort are still too small to push around the stock market. In the Americas, exchange-traded products represent just a fifth of all assets held in funds, while in Europe, that proportion falls to 7%, according to Bloomberg Intelligence.

Still, passive flows have clearly made waves in certain corners of the stock market. Earlier this year, overseers of the S&P Global Clean Energy Index expanded the gauge after ETFs tracking the benchmark started owning ever-bigger stakes in a limited number of companies. That risked giving them too much power over prices and raised liquidity risks especially in a selloff.

A similar issue plagued an index of gold mining companies after ETFs tracking the sector swelled their holdings to the kind of stakes usually associated with large institutional or activist investors.

In a surprising conclusion, the survey found that just 3% of respondents used ETFs tracking ESG themes, while only 8% planned to do so in the future. That comes even as inflows into equity-focused ESG ETFs are on track this year to break 2020’s record of $31.1 billion.

“Perhaps much of the growth in ESG ETFs has been in the retail market,” the survey’s authors conclude.

©2021 Bloomberg L.P.

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