There will be a correction but ETFs probably won't cause it


Here's why I find the stock market fascinating: you have thousands of highly intelligent people researching and debating the economy, markets, and prospects for individual companies. And unlike university dons in ivory towers, these participants are backing their arguments with cold, hard cash. What's more, the performance of markets means we can have a 'winner' at the end of argument as well.

But given how fierce the debate can be, it's a bit surprising that you often see a fair bit of consensus in the ongoing investment 'chatter' that surrounds markets. The beginning of this year is a good example. Again and again, I heard that US stocks were over-valued and now was the time to be invested in emerging markets and Europe. And I agreed. Yet it's a trade that hasn't worked out well so far. The MSCI Emerging Markets index is down 8% since January whilst the S&P 500 in the US is up by the same amount. Sometimes the consensus is wrong.

The consensus was clearly wrong in January - at least in the short term, anyway. But I haven't really changed my mind on the outlook for markets since then. US shares still seem over-valued to me (although some value stocks look reasonable), and regardless of the Trump trade war, emerging market shares look cheap.

The great unknown though, is when US shares will fall back? And what might trigger a fall in American share prices?


One possible trigger or contributor to a US market correction (or crash) is something going wrong with ETFs. Let's look at some of the arguments for this view.

First up is the scale issue. ETFs have grown at a very rapid pace over the last decade and there's always that concern that anything which has grown quickly must be heading for a fall. I don't buy that.

Linked to this is the concern that ETFs are driving more and more money into a few already over-valued stocks such as Amazon and Netflix. If you buy this argument, a rising share price for a company like Amazon just triggers more share purchases and the price carries on rising. It's impossible to prove this one either way, but intuitively, it does make some sense. Remember though that if this is a valid concern, it applies to all passive funds, not just ETFs. (And, of course, there are a few active ETFs out there too.)

What's more, I don't think that ETFs and other passive funds can push valuations massively out of line. That's because there are still plenty of active investors who are itching to make profits from any distortions that might be created by passive funds and ETFs.

The other big issue is the way that ETFs are constructed. This issue was explained to me by Helen Thomas of the Blondemoney website when we spoke on the latest edition of 'The Big Call Radio Show.' Helen pointed out that with many ETFs, the liquidity of the ETF is greater than that for the underlying asset. This isn't the case for a FTSE 100 ETF - those large companies are just as liquid as an ETF.

But if, for example, the asset is corporate bonds, it's a different story. Corporate bonds aren't as liquid as FTSE 100 shares - they're more difficult to trade in large volumes, and some corporate bonds are very hard to access for retail investors. So the corporate bond ETFs are much more liquid than the corporate bonds held by the ETF. If we saw corporate bonds falling significantly, Helen thinks that ETFs could accelerate those falls. Sales of the ETFs could be automatically triggered and if ETF units are redeemed, market makers would face a glut of corporate bonds they couldn't sell easily. Hence prices would fall further.

Helen cites what happened at the end of August in 2015. Markets were quiet as many senior fund managers and traders were on their summer breaks. However, concerns were rising about what was happening in China. The Chinese renminbi was falling and authorities seemed supportive of that depreciation. That triggered concerns about contagion across other markets. As assets fell quickly, it became hard for market participants to calculate the value of an ETF's 'basket.' (The basket is used as part of the creation or redemption process for ETFs.) That meant that some ETFs were no longer priced at the same value as the underlying assets.

This 'dislocation' only lasted a few hours, 'but in a panic, the arbitrageurs don't want to buy…from recent events , we know that fear can take hold', says Helen.

Helen makes a fair point here, but I think she's showing that ETFs may speed up any market correction but they probably won't trigger it.

So, in truth, I don't know what will trigger the next market correction, but I suspect it won't be ETFs. That said, there will be a correction sooner or later, there is always this. And given that US shares are on the higher valuation, there's got to be a decent chance the correction will start there.


No ETFs to show.