Klar­man Shows the Real Dan­ger That ETFs Pose to Markets

The Economic Times - - Companies: Pursuit Of Profit -

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.

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