«ETF bubble» – much ado about little risk?

In the US, passive investments, primarily ETFs and index funds, now account for more than 50 percent of the total equity fund volume. What began in the 1970s as John Bogle's ridiculed idea – «Don't look for the needle in the haystack, buy the haystack!» – is now the dominant force in the investment world.

The fear is that if everyone invests passively, at some point no one will analyze balance sheets and income statements anymore. As a result, there will be more mispricing and market efficiency will erode.

Criticism of passive investing comes less from academia than from active fund managers and well-known Wall Street personalities. In the first case, this criticism is directly understandable, as passive investing costs them market share.

Michael Burry, who rose to fame through the movie «The Big Short», compared the boom in index funds to the subprime mortgage bubble. He criticizes the fact that pricing on the stock market is no longer based on fundamental analysis, but on massive capital inflows into ETFs. Cathie Wood (ARK Invest) criticizes traditional indices such as the S&P 500 for being backward-looking and directing capital into old industries rather than disruptive innovations.

The idea of a passive tipping point is fascinating in a way, but on closer inspection it is unfounded. We explain why.

Trading volume: Who sets the prices

Although ETFs hold over 50 percent of fund assets, they are «silent» owners. They simply buy and hold. And although passive funds have grown significantly, over 90 percent of daily trading volume still comes from active players such as hedge funds, high-frequency traders, and managed equity funds. Pricing takes place precisely there – in a fraction of a second, depending on the news.

A look at current research confirms this: although economists are still debating the exact percentage of the inefficiency threshold, simulations provide reassuring evidence. The models show that a share of 10 to 20 percent of active traders is sufficient to keep prices largely efficient. Why? Because this small group is responsible for a disproportionate share of daily trading volume.

The moment the market becomes «stupid», the potential alpha (the possible excess return) increases. This creates a financial incentive for investors to become active. The market thus has a self-correcting mechanism and heals itself.

When substance stops the sell-off

In times of crisis, investors sell their ETF shares as a whole. This means that fundamentally healthy companies are also sold, simply because they are included in the same index. This can certainly increase volatility.

But here, too, a correction is already waiting in the wings. If a valuable and profitable company such as Nvidia suddenly became too cheap in the context of a broad sell-off, it could either delist itself from the stock exchange or seize the opportunity and strike via a share buyback. These are the ultimate price anchors that can hardly be undercut. But it shouldn't come to that, because the buying opportunity would already be too attractive on the way there. For value investors, it would be lucrative in the long term to jump in during the sell-off. At the same time, this would eliminate the inefficiency.

Conclusion

For private investors, ETFs remain the first choice for profiting from the market at low cost and avoiding the risk of individual stocks. An ETF itself does not set prices; it merely accepts them. As long as there is a critical mass of active traders who react immediately to any mispricing with purchases or sales, the price formation mechanism remains intact and prices remain «fair». What no one can quantify is exactly how large (or rather small) this percentage needs to be. Equilibrium forces will determine it – today as well as in the future.