Are ETFs 'Weapons of Mass Destruction'?

Passive investing vehicles and exchange-traded funds (ETFs) in particular have grown at an incredible pace in recent years. What's more, according to Ernst & Young's Global ETF Survey, this expansion is forecast to continue for the foreseeable future. While many investors are drawn to ETFs for their low costs and reliable returns, it's important to keep in mind that there may be risks associated with the ETF market's growth as well. Indeed, borrowing from a 2003 statement in which Warren Buffet called derivatives "weapons of mass destruction," FPA Capital fund managers Arik Ahitov and Dennis Bryan have adopted the same highly charged terminology for some elements of the ETF world.

According to a report by Seeking Alpha, Ahitov and Bryan point to ETF "weapons of mass destruction" as those funds that have the potential to distort stock prices and to inspire a large-scale market sell-off. For JPMorgan's Nikolaos Panigirtzoglou, the rise of ETFs suggests several other risks as well. First, he suggests that markets become riskier the larger that the ETF space becomes. He says that "the shift towards passive funds has the potential to concentrate investments to a few large products. This concentration potentially increases systemic risk, making markets more susceptible to the flows of a few large passive products." (For more, see: The Biggest ETF Risks.)

Panigirtzoglou also suggests that the rise in prominence of ETFs favors large caps as a result of equity indices tending to be market cap weighted. He adds that "this could exacerbate the flow into large companies beyond to what is justified by fundamentals, creating potential misallocation of capital away from smaller companies ... the risk of bubbles being formed in large companies, at the same time crowding out investments from smaller firms, would significantly increase."

Furthermore, crashes could become more extreme. Panigirtzoglou adds that "the shift towards passive funds tends to intensify following periods of strong market performance as active managers underperform in such periods ... in turn, this shift exacerbates the market uptrend creating more protracted periods of low volatility and momentum. When markets eventually reverse, the correction becomes deeper and volatility rises." (See also: ETFs: A Derivative by Any Other Name.)

Seeking Alpha points out that the stock market has not yet experienced a major downturn since ETFs have occupied their current position of prominence. While it's very difficult to anticipate how the growth of the passive investing area could play into such a market movement, analysts agree that there are meaningful and serious systemic risks.

One of the major concerns about ETFs during a market pullback is that investors will all be drawing from the same basket of stocks when they sell. Equity index flows will reverse, and investors will come to the realization that they are not at all diversified.

Investors looking to avoid investing in mega ETFs that are full of overvalued and potentially risky stocks may wish to seek out what is known as an illiquidity premium. Liquid investing aims for equities that are traded at lower frequencies than their competitors in the market; they are identified by low trading volumes and large bid-ask spreads. Because less liquid stocks are seen as riskier than more liquid ones, there is a premium associated with this group, and that suggests that there may be the potential for outperformance over the long term.

There are already ETFs that are designed to capitalize on this liquidity concern. The Vanguard U.S. Liquidity Factor ETF (VFLQ), for instance, makes use of several measures of liquidity in developing its basket of holdings. As more investors in the growing ETF space become concerned about the large-scale risks associated with some of the most prominent ETFs in the world, it's likely that new entrants to the field will take considerations like this one to heart more and more frequently. (For additional reading, check out: Advantages and Disadvantages of ETFs.)