Record-breaking 2017 for ETFs fuels fears of stock market bubble – Financial Times

Exchange traded funds have attracted the biggest inflow of money in the first two months of the year on record, heightening concerns that ETF buying is fuelling an unsustainable price bubble in the US stock market.


Inflows into ETFs in the first two months of 2017

Investors across the world ploughed $131bn into these index-tracking funds in the first two months of 2017, according to ETFGI, a London-based consultancy. This follows a record-breaking year in 2016, when ETF managers gathered more than $390bn in new cash.

Donald Trump’s election as US president in November gave the already booming ETF business an extra shot in the arm. Encouraged by Mr Trump’s promises of sweeping tax cuts and large increases in infrastructure spending, investors have rushed into the US stock market via ETFs.

“We have seen a huge amount of money pour into US equity ETFs since the presidential election in November and that has contributed to the move higher in the stock market,” said Nick Nelson, an equity strategist at UBS, the Swiss bank. The US stock market hit an all-time high in early March.

Dan Mannix, chief executive of RWC, the UK asset manager that focuses on actively picking stocks, said he feared unsophisticated investors were being “sucked into the market” because ETFs were cheap. There were dangers if ETF flows reversed, he said.

“There is a risk that the tide will turn.

“Much of the capital in ETFs is short term, so we could see rapid outflows followed by a vicious circle where falls in asset prices lead to more selling pressure from ETFs,” he said.

Mr Mannix added this would affect retail investors disproportionately as they were less nimble than other market participants that use ETFs.

The 11.6 per cent rally for the S&P 500 index since Mr Trump’s election means the US stock market is currently trading on a historically high valuation multiple of around 18x future earnings.

Albert Edwards, a strategist at Société Générale, the French bank, said the US stock market valuation was “totally unjustified”, with the S&P 500 now trading at a large premium compared with equity markets in the eurozone and Japan.

Mr Nelson said investors who recently allocated money to the US stock market might find themselves disappointed by corporate earnings growth this year, unless Mr Trump’s promised reforms become reality and provide fresh impetus for business activity.

“ETF investors could find themselves exposed to disappointment unless we see positive news on corporate tax cuts or infrastructure spending, as the earnings cycle in the US equity market has now reached a more mature stage,” he said.

Rising investor demand for low-cost ETFs has intensified pressure on traditional active fund managers, which charge relatively high fees. BlackRock and Vanguard have already pulled in net ETF inflows of $38bn and $29bn so far in 2017, with much of that money diverted from active rivals.

Euan Munro, chief executive of Aviva Investors, the asset management arm of Aviva, the UK insurer, warned that there were worrying similarities between the current fashion for ETFs and the damaging bubbles that developed in technology stocks in 1999 and the financial sector in 2006.

Mr Munro, whose company sells both active and passive funds, said investment trends tended to reach their maximum just as the tide was about to turn.

“The tide will also turn for ETFs, as returns from trackers following broad equity indices are likely to be lower in the future than those achieved historically,” he said.

ETFs have encountered difficulties in the past when markets have moved in unexpected directions. More than a fifth of US-listed ETFs were forced to stop trading on August 24 2015 after the Dow Jones Industrial Average dropped sharply in the first few minutes of the day and rebounded soon afterwards.

Chris Ralph, chief investment officer at St James’s Place, the FTSE 100 wealth manager that invests in both active and passive funds, said: “My concern is that ETFs will not prove as liquid as investors expect if they are looking for an exit in a market downturn. We have seen previous instances when market conditions were more volatile and ETFs did not perform as investors expected.”