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The unforeseen consequences of alternative equity index ETFs
Exchange-traded funds (ETFs) have democratised alternative approaches to passive equity investing. However, the shift in investor preference for alternative index strategies over broad market strategies may be storing up trouble.
Renewed interest in alternative approaches to passive index investing has spawned hundreds of new exchange-traded funds (ETFs) targeting sectors, factors and investment themes.
Recent fund flows data suggests that these alternative equity index ETFs are even more popular than traditional broad market cap-weighted ETFs. Over the past five years, about US$6 in every US$10 that has flowed into US equity ETFs has gone towards alternative equity index strategies.
However, there are signs emerging that fund flows can impact underlying stock prices. We show that ETFs are collectively overweight the largest companies in the US equity market. This has resulted in these companies receiving a greater proportion of passive flows than their market cap weight would justify, potentially causing prices to deviate from where they would otherwise be.
In addition, while liquidity is a major benefit of ETFs, it is also open to misuse. Our research finds that, in aggregate, investors are poor at timing their ETF investments and would do better by adopting a “buy and hold” strategy.
The risk is what happens when there is a reversal of fund flows, as is inevitable at some stage. The active nature of ETF trading suggests that this could happen abruptly. If the tide of money reverses, then stocks that were disproportionately bought will be disproportionately sold, worsening a market drawdown.
To find out more, read the full paper below: