Index ETFs a Ticking Time Bomb?

Index ETFs are much like a mirage, what we see on the surface hides much of what lies beneath. The illusion lies in the top 10 stocks vs the bottom 400.

That illusion gets created by the largest market capitalization-weighted stocks having an outsized influence on the index.

Specifically the top-10 stocks in the S&P 500 index comprise more than 1/3rd of the entire index. Which means, a 1% gain in the same top-10 stocks is the same as a 1% gain in the bottom 90%. 

According to ETF.com, the number of index ETFs that own the same top-10 companies in the S&P 500:

363 own Apple

532 own Microsoft

322 own Google (GOOG)

213 own Google (GOOGL)

424 own Amazon

330 own Netflix

445 own Nvidia

339 own Tesla

271 own Bershire Hathaway

350 own JPM

Just 10 stocks comprise approximately 25% of all issued ETFs. 

Therefore, as investors buy shares of a passive ETF, the shares of all the underlying companies must get purchased. Given the massive inflows into ETFs over the last year and subsequent inflows into the top-10 stocks, the mirage of market stability is not surprising.

Of course, that will change if, and when, investors who are “passive investing” become “active sellers.”

The “stability” provided by passive index buying will also ultimately be the source of “instability.” 

When so many ETFs own the same company, the “liquidity” problem becomes evident during a market rout. 

There is a true statement about how markets work.

“For every buyer, there is a seller….at a specific price.”

This surge in selling pressure creates a “liquidity vacuum” between the current price and a “buyer” willing to execute. 

While “passive indexing” sounds like a winning approach to “pace” the markets during the late stages of an advance, it is worth remembering it will also “pace” just as well during the subsequent decline.