For those that don’t know, an ETF or Exchange Traded Fund is a type of investment fund that can be bought and sold like any other regular ASX listed stock on the sharemarket. They are generally passive in nature, meaning that they track the market index and don’t look to outperform. Although there are active ones as well. The reason one would purchase an ETF is because they’re cheap and easy. What better way to gain exposure to the entire Dow Jones Index than by purchasing an index ETF. No research required. No skills required. Just buy. A few clicks and bang you’ve got low cost exposure to every company in the Dow Jones Industrial Index. Best part about it, is that the entire process is so simple. No W-8 BEN forms and no US estate tax implications for investors. So what’s the problem? The problem is that ETFs have suddenly become the flavour of the month and have exploded in popularity. According to Stockspot the ETF market in Australia grew from $21.3bn to $27.2bn in just 2017. That’s a 28% increase. The size of the ETF market has more than doubled in Australia since 2014 as ETFs have become increasingly popular with individual investors, advisers and SMSFs. The global ETF market is now $5 trillion and that figure is climbing every day as investors flock to the low-fee model of passive investment schemes over active managed funds. In the US it’s roughly 10% of US stocks’ market value and 1% in Australia. The ETF industry is controlled by the two of largest asset management companies, BlackRock and Vanguard. In January this year, BlackRock recorded inflows of US$28bn up 46%. As you can see, ETFs are attracting huge capital inflows from the investment world but this has raised concerns that the very ETF model itself is inflating the market and blindly pushing up stock prices. Fund manager FPA Capital has said “The flood of money into passive products is making stock prices move in lockstep and creating markets increasingly divorced from underlying fundamentals”. Their argument is basically saying that as more and more money is pumped into passive ETFs, the underlying stocks are being purchased without considering the underlying fundamentals of the companies. In most cases, investors don’t even know what the underlying assets are when they purchase an ETF. The flood of money into ETFs causes the underlying share prices to be bid up to prices that do not support those company’s true fundamentals. Does this remind you of anything? Maybe a bubble? Perhaps. An inflating bubble that could eventually burst. That’s the problem. If a market crash is triggered for what-ever reason, ETFs will sell on-mass and compound a sharemarket crash ten-fold. And then you’ve got leveraged ETFs which uses derivatives to amplify returns on the way up but the downside may magnify losses on the way down. One of the greatest advantages of an ETF also becomes its Achilles heel. As easy as it was to purchase an ETF, it’s also as easy to offload it. In times of panic selling to prevent further losses, investors will offload their most liquid assets. Think of the ramifications. It’s not just ETFs that fall in value, it’s the underlying securities that are sold off as well, creating a contagion effect. The house of cards beings to tumble and soon…

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