The rise of the exchange traded fund (ETF) industry is accelerating according to the latest data for the quarter ending September 30 2019 out of leading ETF provider Vanguard.
Year-on-year Australian ETF FUM growth climbed 32% to $56 billion, with a record $4.3 billion of inflows over the September quarter alone.
The inflows are split across property, multi-asset, fixed income, infrastructure and other asset classes of ETFs, but around one quarter of all inflows are going into Australian equity ETFs according to Vanguard’s numbers.
Some of these ETFs are actively managed Australian or international equity funds such as the Magellan Global Trust (ASX: MGG) or VG1 Partners Global Investments Ltd (ASX: VG1), but the majority passively track major indices like the S&P/ ASX200 (ASX: XJO).
This is important for local equity investors as the flood of money going into index tracking funds is potentially distorting the valuations of companies that join or leave indices as a result of S&P’s quarterly reshuffles based on market capitalisations.
For example recently the likes of Polynovo Ltd (ASX: PNV), Collins Foods Limited (ASX: CKF), Pro Medicus Limited (ASX: PME), Jumbo Interactive Ltd (ASX: JIN) and Clinuvel Pharmaceuticals Limited (ASX: CUV) have all rocketed in value just prior to or subsequent to joining the S&P/ ASX200 on either June 24 or Sept 23, 2019.
Evidently their promotion is in part due to strong operational performance which translates into a rising share price.
However, the meteoric share prices rises are also the result of index funds being forced to buy into relatively illiquid stocks.
While algorithmic, robot, or day traders are probably also buying them prior to their inclusion in indices to turn a profit by selling onto index funds.
As more money is allocated to index funds index constituents receive ever greater buying support regardless of their valuations, with less liquid or smaller stocks by capitalisation hitting the strongest updrafts.
Recently high profile economist and hedge fund trader Michael Burry of “Big Short” fame has claimed the wall of money flowing into index funds has blown up some equity asset valuations to bubble-like proportions.
If we look at some of the aforementioned businesses’ valuations his argument might hold water.
As Burry says the kicker is that the index trade is getting ever more crowded, but the exit door is the same size. Evidently investors should tread carefully.
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Tom Richardson has no postion in any stock mentioned.
You can find Tom on Twitter @tommyr345
The Motley Fool Australia's parent company Motley Fool Holdings Inc. owns shares of and recommends Jumbo Interactive Limited. The Motley Fool Australia's parent company Motley Fool Holdings Inc. recommends Pro Medicus Ltd. The Motley Fool Australia owns shares of and has recommended Pro Medicus Ltd. The Motley Fool Australia has recommended Collins Foods Limited and Jumbo Interactive Limited. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.