Numbers are huge

They include more than $US1.7 trillion tipped into the global ETF market over the past five years, around $US335 billion so far in 2017, well above 2016's record intake of $US390 billion. Some say more than $US4 trillion is now invested in global ETFs.

BlackRock, for example, received a record $US138 billion in 2016 into its exchange traded arm but in the first six months of 2017 has already taken $US140 billion.

Just how much more money is tipped in over the second half is anyone's guess but it's hard to see the trend stopping anytime soon.

Little wonder there are some concerns then that this passive style of investing is fuelling a price bubble on Wall Street.

Vanguard, the original passive investment giant, now holds 7 per cent of the S & P 500 index, while critics say that all the money has led to sky-high valuations on a few key big stocks, kept volatility at unrealistic low levels and will even lead to lower economic growth.

In 2010 Vanguard had a 5 per cent stake in 116 stocks in the blue chip index but it now owns at least a 5 per cent stake in 491 stocks.

The whole industry has come a long way since 1993 when State Street Global Advisers launched the first SPDR S & P 500 ETF with hopes of getting around $US1 billion.


That ETF now has around $US125 billion under management.

A liquidity problem?

Michael Hartnett, chief investment strategist at Bank of America Merrill Lynch, wrote a report last week and told clients that ETFs could end up causing a huge liquidity problem.

He also went on to say that "the actual shares available, or true float for S & P 500 stocks, may be grossly overestimated."

The sheer weight of money pushes up prices to unrealistic levels but it can also be a problem for short-sellers as the flow of money means the buying just rolls on.

It means traditional asset managers get stung twice.

Once by investors taking money away from them as they chase the cheaper passive funds that track an index , which means less fees, and then by trying to find stocks that are cheap.

The volume of money tipped into index funds has also helped keep volatility artificially low.


Fresh money

How can there be a pull back when so many billions of fresh money is ploughed into the index every day?

The longest, lasting sell-off on Wall Street since Donald Trump was elected President in November, 2016 – a move that sparked further inflows into index funds – went for just three days.

And that was in late December, from the 28th to the 30th, when volumes are seasonally light anyway and can easily be pushed around.

Big money to small number of stocks

The other distortion that shows up is the amount of money that ends up going to a small amount of stocks due to their weighting in the index.

Think Amazon and Facebook.

Indeed, just over 10 stocks have got close to 12 per cent of flows into US equity ETFs, despite accounting for 14 per cent of the float-adjusted capitalisation.


Passive funds have accumulated a 40 per cent market share in the United States , and growing, while it's as high as 50 per cent in Switzerland, according to AllianceBernstein.

In some markets there are now more indices than there are large cap stocks.

Music legends jump in

In another sign of just how popular these ETFs are getting investors might soon be able to invest in one linked to music legend Quincy Jones.

The producer behind some of Michael Jackson's biggest hits won't be managing any money or buying stocks but the name the Quincy Jones Streaming Music, Media & Entertainment ETF has been registered.

David Bowie also used the financing technique known as securitisation to sell off the future earnings of some of his records.

The US sub-prime housing market was brought to life by the securitisation process.

It is one criticism of ETFs , that they are simply another modern day Wall Street financial innovation that has been designed to help bankers get their bonuses.


Furthermore, if history is any guide, these financial innovations don't have a great reputation for making investing any safer or more profitable for investors.

But if investors want to get exposure to a market, then ETFs do all that they say they will.

What investors should really focus on is does the product help them achieve their end goals.

To be fair, there are more than just a few active managers that include some passive investing through ETFs in their top portfolio holdings.

Rather than being active they match the passively tracking market indices, but still charge the high fees for doing so.

The chequered performance of active managers also makes it hard to argue against ETFs.

Trading and investing

One important distinction to make is when ETFs are used for trading and not long term investing.


Some say they can make it easy to get in and out of the sharemarket with a single click but that leads to retail investors buying and selling at the wrong time.

Australian investors have been slow to latch on the whole process because there was no incentive for financial planners to sell them. But that has changed in the past few years.

The other short term challenge facing investors is the upcoming US June quarter earnings season.

At first glance consensus forecasts are predicting a 7.4 per cent year on year rise in earnings but the end result could be as high as 10 per cent.

With Wall Street hovering close to record highs the upcoming reports season is seen as vital to justify the gains that have been made so far in 2017.

While the major S & P ASX 200 index is up 1 per cent calendar year to date the S & P 500 is up 8 per cent and the Nasdaq as much as 14 per cent.

It comes as the S & P 500 is trading on a forward 12-month price earnings ratio of 17.3 times.

That compares to an average over the past five years of 15.3 times earnings, while over the past 10 years the average forward P/E for the S & P 500 is closer to 14 times.


Not surprising then that all nine sectors have a forward 12-month P/E ratio that is above their 10-year averages.

Expensive stocks

There's no doubt US stocks are looking expensive and with further rate hikes from the Federal Reserve just around the corner investors will want to see a solid reporting season.

On the score investors have history on their side.

Since 2012, on average, actual earnings reported by S & P 500 companies has been better than initial estimates by around 4 per cent.

Some of that can be explained by companies under-promising and over-delivering.

According to Fact Set, the key nine sectors, including energy, are expected to report earnings growth for June quarter, while of the 5 per cent of companies that have already reported, most said that if the strong US dollar wasn't a negative factor on earnings or revenues in the quarter, it will have a negative impact down the track.