ETF: How index trackers can ruin the market

Doomsday scenarios about ETFs abound. The basic premise is that ETFs and other index-tracking investments will one day become so large that it will destroy the financial market as we know it.

Price discovery causes the most consternation. In a perfect world, the forces of supply and demand regulate price. Because index trackers buy shares at the current market value, the first worry is that nobody would check the valuations of companies anymore, leading to prices that don’t accurately reflect the fair value of the company. The second fear is that index trackers would create a huge artificial demand for shares, pushing share prices beyond fair value.

Since index trackers are indiscriminate buyers of companies that meet the index criteria, there’s further anxiety around the inclusion and support of companies that have run their usefulness. If an index tracker becomes large enough, it could create its own market for a company that manufactures a product that nobody uses anymore, for example. Since not enough active buyers participate in the market in this scenario, the index could prop up a dead company.

Index investment sceptics predict a mass exodus of ETF investors once the index-tracking industry becomes large enough to eat itself. Since the industry is growing by the day, a huge sell-off of ETF shares will break the market a second time.

As an ETF investor, it’s prudent to be aware of these concerns. While index-tracking instruments try to replicate the performance of the market, a bad market isn’t your only risk. As tempting as it is to dismiss these concerns as active management propaganda, you remain responsible for your wealth.

It’s advisable that you familiarise yourself with these arguments and draw your own conclusions. A quick Google search will get you more than enough to start with. You can also read this opinion piece. Internalise the arguments, but be circumspect about the sources. Someone with skin in the active game has a lot of incentive to discredit index-tracking products. That doesn’t necessarily invalidate the arguments, of course, but it does provide context.

Secondly, be very sure you understand your exposure. Do you know which regions and industries your wealth is exposed to? Do you understand what bad news in those regions or industries could mean for your portfolio? Do you understand different asset classes and their associated risk?

In this Fat Wallet Show, Simon and I talk about the possibility of ETFs breaking the market. If you are interested in our views, listen here.

Lastly, this quote from the Bloomberg opinion piece is worth remembering, “No one knows the basic laws that govern asset markets, so there’s a tendency to use new technologies until they fail, then start over.”