As ETF investments outpace active strategies, concerns about potential risks arise. While Burry raises alarm, current data points to a more tempered reality.
For the first time in 2024, in the United States, the capitalization of passive funds surpassed that of active funds—a historic milestone that has ignited significant debate among experts regarding its broader implications.
This shift has notably raised concerns from one of Wall Street’s most prominent contrarian voices, Michael Burry, renowned for predicting the 2008 subprime mortgage crisis.
According to Burry, the widespread proliferation of ETFs is creating a financial bubble with dynamics reminiscent of those that triggered the 2008 collapse. But how valid are these concerns?
ETFs and the Rise of Passive Investing
ETFs, or exchange-traded funds, are financial instruments that track the performance of a market index, enabling investors to gain exposure to a basket of securities through a single transaction. Their appeal lies in low costs, flexibility, and liquidity. ETFs trade like regular stocks and, due to their passive nature, offer significantly lower fees compared to actively managed funds.
Additionally, research consistently shows that passive funds often outperform active funds over the long term, as the latter must justify their higher fees with superior returns. These factors have driven the growing preference for ETFs among investors, particularly retail investors, while actively managed funds have steadily lost market share.
While this shift appears advantageous, especially for individual investors, Burry warns that it may disrupt the market’s natural dynamics.
Burry: "ETFs Threaten Price Discovery"
Burry contends that the growing dominance of ETFs undermines the critical process of price discovery.
In a well-functioning market, stock prices are driven by fundamental analysis, with active investors evaluating metrics such as company earnings, balance sheets, and growth prospects to determine a stock’s intrinsic value. In contrast, ETFs purchase stocks based solely on their inclusion in an index, irrespective of their underlying fundamentals.
For instance, an ETF tracking the S&P 500 index buys shares of the 500 largest companies by market capitalization, assigning weights proportionally. Consequently, as a stock’s price and market cap rise, ETFs automatically allocate more capital to it, further driving up its price—even if its fundamentals are weak. This self-reinforcing mechanism, Burry argues, can lead to market distortions, where overvalued stocks become increasingly inflated, while undervalued ones are overlooked.
Are ETFs Driving a Speculative Bubble?
Although Burry’s concerns are thought-provoking, recent studies suggest that the risk of an ETF-induced bubble may be overstated. The majority of ETF trading occurs in the secondary market, where investors exchange ETF shares without the fund directly purchasing the underlying assets. According to BlackRock, less than 10% of U.S. trading volume is directly linked to ETFs, meaning fundamental analysis still largely influences price discovery.
However, a more tangible risk lies in the growing concentration of voting power among asset management giants like Vanguard, BlackRock, and State Street. These firms rank among the largest shareholders of major corporations, wielding considerable influence over corporate governance.
When investing in ETFs, individual shareholders forfeit voting rights attached to their holdings, which are transferred to the fund managers. This consolidation of influence can impact corporate decision-making and the allocation of resources across the economy.
A Consequence: Dividend Aristocrats Underperforming the Market
One notable impact of the shift toward passive investing is the relative underperformance of Dividend Aristocrats—companies with a 25+ year history of consistent dividend growth. Historically regarded as some of the most financially robust and high-performing stocks, their edge has diminished since 2020.
The rise of ETFs has led to capital being broadly distributed across indices, often favoring companies with larger market capitalizations, regardless of their intrinsic merits. This trend has reduced the annualized returns of Dividend Aristocrats compared to the broader S&P 500 index. The divergence has become especially pronounced in the aftermath of the COVID-19 pandemic, as passive funds have eroded the market share of active fund managers.
This development underscores how the market is increasingly favoring broad diversification over the selective, targeted strategies traditionally employed by active managers.
Should We Be Concerned?
Burry’s warnings highlight important challenges, but current data suggests that the risk of an ETF bubble remains limited. Active investors continue to play a pivotal role in price discovery, and the market does not appear to face an imminent collapse. However, the concentration of power among a few major asset managers and the automatic allocation of capital by passive funds are trends worth monitoring closely.
Original article published on Money.it Italy 2025-01-19 11:27:00. Original title: Gli ETF sono in bolla speculativa? Sì, e sta per scoppiare secondo chi aveva previsto la crisi del 2008
