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Seth Klarman, president of The Baupost Group, speaks during the Ira Sohn Investmen Research Conference in New York, U.S., on Wednesday, May 26, 2010.Daniel Acker/Bloomberg

Many analysts have spent years criticizing exchange-traded funds.

They've become louder over the years as ETFs became increasingly dominant, siphoning off a growing proportion of overall investor money in funds. This is especially true of fixed-income ETFs, which have been rapidly gaining traction and have the added complication of trading like stocks but tracking less-active bonds.

Critics say these funds are potentially dangerous and untested through a crisis, but the complaints have largely fallen on deaf ears. Investors of all types, from individuals to hedge funds, have increasingly gravitated toward these funds for their low fees and easy access to entire asset classes. Debt ETFs in the U.S. attracted nearly $100-billion over the past 12 months, boosting their assets by 20 per cent, according to Bloomberg data. Passive bond funds now account for more than one-fifth of the fixed-income market, according to one measure recently reported by the Financial Times.

It's true that ETFs, particularly those focused on fixed income, haven't survived a crisis in their current form. But that's an exceedingly vague concern, and one that's been vehemently debated by regulators and fund managers alike. These aren't all that different from mutual funds, after all. Instead, Seth Klarman, the respected founder of the Baupost Group, put his finger on the broader, more tangible issue in a recent letter to investors. The dominance of ETFs is making markets less efficient, and this could end up causing harm.

As Mr. Klarman wrote in his recent note, "The inherent irony of the efficient market theory is that the more people believe in it and correspondingly shun active management, the more inefficient the market is likely to become."

Here's how this works: Most ETFs aim to track indexes. These indexes are usually dominated by the biggest companies with the most public debt and equity outstanding. As money is funneled into these passive funds, it goes disproportionately to these big and leveraged companies simply because of their weighting in their indexes.

So as markets rise and cash pours into ETFs, these dominant securities will perform well relative to everything else. The longer this persists, the more a company's bonds and stocks can generate returns that are superior to what their fundamentals suggest.

The effects of this are significant. It means that bubbles can form and rapidly inflate relatively unchecked by active managers, at least relative to the past. And even if active managers come in and try to sell these companies short, they may be thwarted by yet another rush of flows into indexed funds.

This is a more subtle danger, but the distortions are real. As markets become more inefficient, it becomes more likely that a surprise could set off a larger, disruptive response. Just think back to September 2015, when large high-yield bond issuer Sprint was downgraded several notches, spurring a furious selloff that bled into broader markets.

Meanwhile, some asset managers are arguing that active managers now have a better chance than they have had in years to outperform indexes, especially for those who steer clear of bonds and stocks that are included in ETFs. Indeed, a broad swath of high-yield bonds that includes smaller issuances has steadily performed better than an index of the biggest, most-traded notes tracked by passive funds.

ETFs will continue to attract a substantial proportion of all new investor money coming into stock and bond markets. Investors appreciate these funds' low fees and easy accessibility. "It is a tangible benefit that stands in stark contrast to the perceived perils of ETFs that are more myth than reality," Bill McNabb, chief executive of Vanguard Group, wrote in a recent column.

While the perceived perils have indeed not fully manifested themselves, it is clear that ETFs are transforming the behavior of markets. And this may end up exacerbating mini corporate bubbles that pop in unpleasant ways.


Lisa Abramowicz is a Bloomberg Gadfly columnist covering the debt markets. She has written about debt markets for Bloomberg News since 2010.

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