Can The Growing ETF Market Lead To The Stock Market’s Undoing?

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A significant uptick in new ETF launches has some investors on edge, with Citigroup U.S. Equity Strategist Drew Pettit telling Reuters that the launches are at an “unsustainable level” that can result in “product rationalization and closures.”

ETFs have become a fan favorite among many stock investors who want a simplified way to enter financial markets, but the growing ETF market can lead to trouble in the overall stock market.

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The growth in ETFs has resulted in more competition, and that creates the stage for many closures. Investors only have so much money to go around, and since smaller ETFs tend to have higher expense ratios, it gives investors less of an incentive to give new funds a chance.

An ETF issuer must publicly announce the fund’s closing date a few weeks in advance, giving investors enough time to exit. Then, the fund delists, liquidates its assets, and distributes cash proceeds to remaining shareholders based on their share of the ETF’s net asset value. This is a taxable event for shareholders.

The closure of a single ETF won’t do much harm to the stock market. If many ETFs shut down, high liquidation can lead to lower stock prices, but investors will receive their money and can simply invest in a similar ETF or buy individual shares of their favorite companies.

If a big ETF like the Vanguard S&P 500 ETF (NYSE:VOO) shut down, it would be a significant liquidity event since it has more than $1 trillion in net assets. However, an ETF with $100 million in assets won’t create as much of a stir if it gets discontinued.

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ETFs can become problematic for the stock market if large funds experience significant outflows. Outflows occur when the amount of investor capital that exits a fund exceeds the amount of capital that enters the fund.

If investors panic during a downward market, such as when President Donald Trump went on a tariff spree at the start of his second term, the downward pressure of ETF sellers can hurt the stock market.

ETFs can also hurt the stock market by making equities overvalued. For instance, many of the top ETFs follow a benchmark like the S&P 500 or Nasdaq Composite, which weigh companies by their market caps.

Under this scenario, the Magnificent Seven stocks don’t have to produce superb earnings to rally higher. As long as investors put more money into index funds, those stocks will continue to rally, regardless of their fundamentals or valuations. It can result in plenty of overvalued stocks, within the Magnificent Seven and beyond, that can come crashing down during the next economic contraction.

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The growing reliance on ETFs isn’t likely to cause a stock market crash. Many young investors have navigated stock market downturns in 2020 and 2022, but older investors have witnessed many additional booms and busts.

Investors who are wary of the growing ETF market or want to outperform the stock market may want to look for individual stocks with smaller market caps and rising revenue. These stocks have potential, but smaller stocks also don’t get as much attention from ETF issuers. It’s only when small-cap stocks become large-cap stocks that they get a lot more attention from ETF issuers.

Stock picking isn’t easy, and if that’s not your thing, you can also opt for one of the large ETFs that mirrors a key benchmark like the S&P 500 or Nasdaq Composite. These funds won’t have to liquidate since they’re so large, and they also have much lower expense ratios than the small ETFs that are just trying to make it.

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This article Can The Growing ETF Market Lead To The Stock Market’s Undoing? originally appeared on Benzinga.com