ETFs are efficient, cheap, popular – but their boom is fundamentally changing the market. As the passive share grows, the risks to stability and pricing increase.
• ETF inflows do not follow fundamental analysis, but rather fixed rules
• Market concentration is increasing, a few heavyweights dominate
• Liquidity, volatility and extreme movements are changing structurally
The democratization of investing has one word: ETFs. Like hardly any other financial instrument, they are a real blessing, especially for private individuals – and above all they are one thing: broadly diversified, cost-efficient and transparent.
But what happens when capital flows into ETFs regardless of fundamentals, crises or valuations? Is the blessing for investors also a curse for the market?
Stabilization with side effects
The private bank Berenberg has a nuanced answer to this: Although ETFs stabilize in the short term through continuous demand, they distort the market and make it more susceptible to extreme movements.
In an article entitled “The more passive, the more problematic?” Ulrich Urbahn, Head of Multi Asset Strategy and Portfolio Management at Berenberg, comments on why the market becomes more unstable as a result of a higher ETF share. Essentially, three central side effects can be identified: higher market concentration, changed liquidity and more volatility.
Market concentration: The big ones are getting bigger and bigger
A central problem initially lies in the mechanics of indices themselves. Capital does not flow to where valuations are attractive, but to where weightings are high. Large companies – especially tech heavyweights – automatically attract the majority of inflows. This leads to increasing concentration: a few stocks dominate the indices and thus also the capital flows. The result: the market becomes more susceptible to cluster risks. If the mood among these heavyweights changes, the entire index is affected – and with it every ETF investor.
Liquidity: Deceptive stability
At first glance, ETFs increase liquidity because they pool trading. In times of stress, however, a different reality emerges: actual liquidity still depends on the underlying individual securities.
In addition, studies on passive investing show that a higher ETF share is associated with increasing bid-ask spreads, higher liquidity risk and greater exposure to market-wide shocks.
In concrete terms, this means: If many market participants want to trade at the same time, liquidity can dry up faster than expected. What is particularly critical is that many passive strategies act at the same time – for example at the close of the market – in order to accurately reflect the index.
Volatility and extreme movements are increasing
However, the effects are most noticeable when it comes to volatility. Passive money flows do not react to news or reviews, but follow fixed rules. In rising markets, they reinforce trends by further funneling capital into stocks that are already doing well. In falling markets, on the other hand, active buyers who have a stabilizing effect are often missing.
Empirical studies show that a higher proportion of passive investors is associated with more short-term price reversals, higher idiosyncratic volatility, and an increasing likelihood of extreme price movements. In this context, Berenberg speaks of more frequent extreme events and a market structure that combines longer phases of relative calm with abrupt shocks.
The larger the share, the greater the structural risks
ETFs have revolutionized investing – but they are also changing the rules of the market. As long as the inflows continue, the system has a stabilizing effect. But the larger the passive share becomes, the more structural risks become apparent. The crucial question is no longer whether ETFs influence the market – but at what point they dominate it.
Benedict Kurschat, editorial team at finanzen.net
