The "wall of momentum" into low-cost passive strategies, particularly ETFs, has already distorted equity markets in Australia and abroad, says Providence Wealth.
The flow of investor money into passive products is making the largest listed companies even larger "irrespective of fundamentals", according to a new report by Providence Wealth Advisory.
In a new white paper titled The Rise of Passive Investing: Fee Saving or Increasing Risk?, Providence said that the momentum into passive products will become "self-fulfilling until it isn't", at which point index fund investors will lose the same amount as the underlying market.
"[ETF inflows] are without doubt impacting the way that companies are being valued in the market globally and how capital is invested," the report said.
"Given that, in many instances, ETFs are essentially replicating an index, the discretion about what stocks to own or not in a portfolio is distorted as every stock is essentially replicated within the ETF irrespective of that individual company’s profitability, management performance and financial stature."
In some instances, this is creating some hyper-volatility on a company-by-company basis, said Providence.
"It is no coincidence that stocks are now far more volatile on the day that any negative news is announced, as it is often the case that they were already mispriced, especially in a rising market, due to the momentum of passive investments," the report said.
"Index funds can play a role in portfolios as a low-cost beta allocation, but we need to keep a watchful eye on the valuations of the index," Providence said.
The report used the word "bubble" to describe current inflows into ETFs, and suggested they could be the "next financial weapons of mass dislocation".
Providence said: "This may be too strong a view; however, care needs to be taken in understanding the structure of the ETFs, and there needs to be an awareness that the efficient pricing of these instruments is reliant on a third party to make the markets, and at times there could be a mismatch in liquidity."
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