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Are Exchange-Traded Funds Sparking A Stock Bubble?

A few years ago during an annual general meeting with shareholders, Warren Buffett mentioned that he believed passive exchange-traded funds (ETFs) were a better alternative to actively managed funds. Passive ETFs charge lower management fees and could potentially return more money to shareholders in the longer-term.

Well, when Warren Buffett speaks, the world listens.

Money has flown into passively managed ETFs in the trillions in recent times. In 2016, for instance, there were 1,560 exchange-traded products on the New York Stock Exchange Arca, which managed a total of US$2.2 trillion and an average daily turnover of over US$90 billion.

These astonishing numbers just go to show how much investor sentiments have shifted towards ETFs and away from actively managed funds.

Over-valued indices?

With more investors turning to ETFs as a way to diversify their portfolio, it is no wonder that index prices have soared. The S&P500 index, one of the most followed stock indexes in the United States, has climbed from around 1,500 points in 2013 to 2,599 points, as of yesterday.

Although most companies within the index have performed well and this has warranted their price increases, some of the rally has to do with the large amount of money that is invested in them through ETFs.

For instance, another index, the Russell 2000 (an index measuring 2000 small-cap companies) was also shown to be trading at a 50% premium over stocks that were not included. This is another indication of how ETFs have caused stocks in indexes to become over-priced.

What about Singapore?

Thankfully, back in Singapore, the problem seems to be very much less pronounced. There are only two funds that track the Straits Times Index (SGX: ^STI) that have total assets under management of less than a billion dollars. This is a minute amount compared to the total size of the Singapore stock market.

What do investors need to do?

Index ETFs can make good investments due to the lower management fees and access to a large portfolio of stocks. However, investors also need to be aware that not all index ETFs may make good investments.

As with any investment, investors need to be wary of the risk and do sufficient due diligence before making a decision.

It is also important that investors who are buying into ETFs diversify their portfolio further by ensuring they also own stocks outside the index and have investments in other asset classes as well.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.