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A trader works on the floor of the New York Stock Exchange (NYSE) Feb. 17.

BRENDAN MCDERMID/Reuters

Exchange-traded funds are "weapons of mass destruction" that have distorted stock prices and created the potential for a market sell-off, 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.

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"This new market structure hasn't been tested," Bryan said in a telephone interview, noting that the stock market has never gone through a major downturn when passive investors were as important as they are now. "We could get an onslaught of selling."

For more than two decades under former manager Robert Rodriguez, Los Angeles-based FPA Capital was among the top-performing stock funds in the U.S. From 1986 to 2010, it returned 14.5 per cent a year compared to 8.5 per cent for the Russell 2000 Index, according to a data compiled by Bloomberg.

Fund Struggles

The fund has struggled in recent years, in part, because the managers, finding too few attractive stocks to buy, have parked 35 per cent of their money in cash. FPA Capital trailed 99 per cent of peers over the past five years and the Russell 2000, with a 4 percent annual return, according to data compiled by Bloomberg. The fund is a concentrated stock fund. Its biggest equity holding as of March 31 was Western Digital Corp., which makes computer-storage devices.

While several high-profile money managers of active funds have raised concerns about ETFs, equity ETFs account for about 7 per cent of the U.S. stock market's value, according to data compiled by Bloomberg.

In a February letter to investors, Seth Klarman, who runs the $30-billion Baupost Group, said that as more investors opt for passive investing over active management "the more inefficient the market is likely to become."

In the same letter, Mr. Klarman cited Nikolaos Panigirtzoglou, a global market strategist at JPMorgan Chase in London, who, according to Mr. Klarman, has warned that the inflows into ETFS will "make markets more brittle" and "susceptible to more severe crashes."

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But Jim Rowley, senior investment strategist at Vanguard Group, disagrees with the naysayers. Vanguard, which has roughly $3-trillion in assets in passive products, including almost $700-billion in ETFs, has examined more than 20 years of market history, he said. The conclusion: markets are as volatile as ever and the dispersion in the performance of individual stocks is as great as it was before indexing became popular.

"We didn't find any relationship between indexing and market dynamics," he said.

Mr. Ahitov isn't totally pessimistic. Should stocks sell off indiscriminately, there will be bargains for smart value investors. "Dennis and I will buy the good stocks that are cheap," he said.

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