Market Watch: Could ETFs cause the next crash?

What is an ETF and why are people concerned? Photo / AP

Exchange traded funds (ETFs) have become one of the hottest asset classes in the world in the past few years but could they be sewing the seeds of the next crash?

Analysts at Bank of America Merrill Lynch this week warned that "ETF-isation" of US markets was eroding liquidity and causing distortions in valuations.

So what is an ETF and why are people concerned?

ETFS are basically like a unit in a managed fund that can be traded on a market like a regular stock, says Pie Funds chief executive Mike Taylor.

"It is a collection of assets , either trying to replicate a sector or a country or an index itself," he said.

They were proving very popular in the bull market because they allowed people to get into specific sectors and then "set and forget", Taylor said.

You could get an ETF for almost anything these days from the Taiwanese index to cyber-security companies.

More than $1 trillion has shifted from traditional mutual funds to ETFs since the GFC.

ETFs currently account for nearly a quarter of US stock-market trading volume versus 76 per cent for individual stocks. Three years ago, ETFs accounted for 20 per cent.

"It's been almost like a tidal wave of money coming out of active mutual funds into passive ETFs," Taylor said.

The big driver had been studies coming out which showed active managers were failing to beat the indexes, he said.

But ETFs were great in a bull market, not so much in a bear market, he said.

"That's where an active manager comes in because they can rotate their portfolio or shift their strategy towards cash."

"The bad thing about an ETF was that at the top of a market it mi allocates capital," Taylor said.

They replicate the index and the index puts it money into the largest companies, he said.

So if you were using ETFs in the tech bubble of 2000 you would have ended up with a portfolio of very expensive tech stocks. Similarly in 2007 and 2008 you'd have had a portfolio with a lot of financial stocks.

With the massive growth in ETF investment there was now a risk that they could create serious imbalances in the market.

- Disclosure: Pie Funds is an active fund manager and does invest in ETFs to gains exposure to specific market sectors.