ETFs and Co. – Curse or Blessing for Financial Market Stability?

Lower costs compared to actively managed funds, a price performance close to the index and diversification with low capital investment: it is not surprising that almost 5 trillion euros are invested worldwide. US dollars can be managed in passive funds (ETFs). The low cost, however, is only one side of the coin. The investment process in an ETF portfolio must also be defined and monitored. This includes aspects such as the definition of the benchmark, stock or index selection, reweighting of positions as well as the consideration of theme investments and other special features. Investors who cannot or do not want to determine and monitor the investment process themselves must ultimately continue to rely on external providers, which in turn leads to higher costs.

However, the world’s two largest ETF providers together manage the equivalent of 15% of US GDP. The volume of managed funds is thus many times higher than that of other capital collection agencies. By way of comparison, Lehman Brothers managed „only“ around USD 250 billion in investment business before its bankruptcy in 2008. Due to these dimensions, scientists and regulators are repeatedly confronted with the question of whether the existence and market power of ETF providers is a curse or a blessing for financial stability.

Some time ago, we too had already dealt intensively with this topic. In fact, passive investing has a multiple impact on the financial markets. One of our most important findings at the time was the observation that ETFs could accelerate both the formation of price exaggerations and the sell-off in the markets due to the trend-setting effect and the high fund volume. In addition, there is a risk of price formation if shares are bought without taking information and analyses into account. In ETF segments with narrow markets, there is a risk that the liquidity reported in normal market situations may prove non-existent during periods of stress. The numerous speculative segments in the ETF market stand out in particular, especially leveraged ETFs, but also other segments within the market for high-yield bonds. Although the ETF market as a whole is now considered large and secure, the smaller segments could become increasingly volatile in the future. Investors should take „accidents“ into account here and concentrate more on the large segments.

Overall, however, there is little evidence that the risks at the overall market level will need to be significant in the near future. On the contrary, in „normal“ market phases, it is rather to be welcomed that trading liquidity is provided by the ETF providers. Finally, regulatory measures in recent years have dried up various collection points for capital (including proprietary trading by banks).
The ETF market should continue to grow over the coming years. While the topic has been established among institutional clients for quite some time, one of the main drivers for passive funds remains the increasing interest of private investors, especially in connection with private old-age provision. In structural terms, economies of scale due to the increasing market power of a few ETF providers have an impact on costs. The fund industry, which continues to be predominantly active, will have to react to the favourable offer of passively managed funds with medium-term cost reductions in order to survive in the competitive environment. Investors should ultimately emerge victorious from the competition between fund providers and the emerging diversity, even in actively managed funds.

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