Are ETFs Weapons of Mass Destruction?

With the huge inflow of asset under management into the ETFs, a natural question arises: how do ETFs influence the markets?

Opinions are diverse. Connected Wealth presented a nice report on Valuewalk and concluded:

The rise of passive investing, mainly via ETFs, appears to be changing the structure of the markets. This could be supressing individual company variance and making the market more macro driven. As more money flows into passive ETFs, this structural change would likely continue to rise over time. At some point this could be a big enough driver to create greater opportunities for more fundamental research to add value. Perhaps opportunities to take advantage of blanket basket driven price moves. Not sure if we are there yet, but it is likely coming. Read more

Other observers are more specific. Dani Burger wrote

Exchange-traded funds are making stock markets dumber — and more expensive.
That’s the finding of researchers at Stanford University, Emory University and the Interdisciplinary Center of Herzliya in Israel. They’ve uncovered evidence that higher ownership of individual stocks by ETFs widens the bid-ask spreads in those shares, making them more expensive to trade and therefore less attractive.
 This phenomenon eventually turns stocks into drones that move in lockstep with their industry. It makes life harder for traders seeking informational edges by offering fewer opportunities to capitalize on insights into earnings and other signals.
The study is the latest to point out signs of diminished efficiency in markets increasingly overrun by the funds. Read more

Similarly, Charles Stein calls ETFs Weapons of Mass Destruction:

Exchange-traded funds are “weapons of mass destruction” that have distorted stock prices and created the potential for a market selloff, according to the managers of the FPA Capital Fund.
“When the world decides that there is no need for fundamental research and investors can just blindly purchase index funds and ETFs without any regard to valuation, we say the time to be fearful is now,” Arik Ahitov and Dennis Bryan, who run the $789 million fund, said in an April 6 letter to investors in the actively managed fund.
The flood of money into passive products is making stock prices move in lockstep and creating markets increasingly divorced from underlying fundamentals, the managers said. As the market moves ever higher, there’s the potential for a sharp decline. The U.S. ETF market has about $2.7 trillion in assets, the majority in products that track indexes. ETFs have attracted more than $160 billion in new flows so far this year, Bloomberg data show. Read more

On the research side, Wesley R. Gray is more conservative, he said:

We’ve heard a lot of questions recently from clients and readers regarding how ETFs might affect financial markets.
The short answer is “nobody knows.” The long answer is researchers are trying to figure it all out. Read more

His post also includes brief summaries of recent academic research.

To conclude, both academic and practitioners communities are still debating on the exact impacts of ETFs on the markets. However, we started seeing a consensus: ETFs will increase volatilities and correlations.