- ETFs have the potential to shake the markets similar to how subprime debt and CDOs did.
- Potential risks come from illiquid underlying assets on secondary markets and poor capital allocation.
- However, this should also create amazing individual investing opportunities for those who are ready.
On the 13th of January, BlackRock (NYSE: BLK) reported 2016 earnings. BLK is the largest global asset manager with $5.1 trillion under management, and the owner of the iShares ETF brand that we often use here for sector performance analysis. What is significant in BLK’s report is that it recorded $202 billion of net inflows. As BlackRock mostly deals with ETFs, the additional inflows went into various ETFs globally.
Of the $202 billion of net inflows, $74 went into iShares equity investments. The $74 billion represents 9% of the total assets iShares had under management at the end 2015, which is very closely correlated to the 2016 S&P 500 index return of 11.3%. This close correlation begs the question, what will happen when the positive net flow of funds reverses?
BLK estimates that the inflows will never reverse and sees $6 trillion in ETFs by 2020.
But inflows will reverse eventually as a market correction—or even worse, a recession—comes along.The positive inflows in passive funds alongside $500 billion in buybacks managed to push the S&P 500 only 11% higher in 2016, indicating valuations are stretched. Passive fund flows will reverse as soon as some kind of fear catches up with greedy investors.
Buybacks will cease with slower economic activity, as they, irrationally, always do.
Additionally, liquidity issues may arise as ETFs are becoming the most traded securities on financial markets.
Only 3 stocks are among the 10 most traded securities
When flows into ETFs reverse, there won’t be anyone there to buy the assets ETFs hold and their managers will be forced to unload them at low prices creating sharp market declines similar to those from August 2015 and January 2016.