Klarman Shows the Real Danger That ETFs Pose to Markets
Bloomberg Gadfly: Many analysts have spent years criticising exchange-traded funds (ETFs). They’ve become louder over the years as ETFs became increasingly dominant, siphoning off a growing proportion of overall investor money in funds. This is especially true of fixedincome ETFs, which have been rapidly gaining traction and have the added complication of trading like stocks but tracking less-active bonds.
Critics say these funds are potentially dangerous and untested through a crisis, but the complaints have largely fallen on deaf ears. Investors of all types, from individuals to hedge funds, have increasingly gravitated toward these funds for their low fees and easy access to entire asset classes.
Debt ETFs in the US attracted nearly $100 billion over the past 12 months, boosting their assets by 20%, according to Bloomberg data. Passive bond funds now account for more than one-fifth of the fixed-income market.
It’s true that ETFs, particularly those focused on fixed income, haven’t survived a crisis in their current form. But that’s an exceedingly vague concern, and one that’s been vehemently debated by regulators and fund managers alike. These aren’t all that different from mutual funds, after all.
Instead, Seth Klarman, the respected founder of the Baupost Group, put his finger on the broader, more tangible issue in a recent letter to investors. The dominance of ETFs is making markets less efficient, and this could end up causing harm. As Klarman wrote in his recent note, “The inherent irony of the efficient market theory is that the more people believe in it and correspondingly shun active management, the more inefficient the market is likely to become.”Here’s how this works: Most ETFs aim to track indexes. These indexes are usually dominated by the biggest companies with the most public debt and equity outstanding. As money is funneled into these passive funds, it goes disproportionately to these big and leveraged companies simply because of their weighting in their indexes.