10 year on since the last financial crisis, interest is growing in when and where the next crisis might occur. Since 2008, the exchange-traded funds (ETFs) market has increased by around 500% in both US and European markets. 

Against the backdrop of this exceptional growth, alarm bells are sounding over liquidity risk in the market – whether the market could handle sudden redemptions. The latest alarm bell comes from analysis by Société Générale. After stress testing 16,000 stocks, its analysts concluded that small caps, dividend shares and gold miners are all acutely vulnerable in market downturns due to outsized ownership among passive investors. The specific concern is that as ETFs continue to grow and gain bigger ownership of stocks, it can reduce the ability of investors to diversify liquidity shocks due to an increase in the commonality in liquidity of stocks included in ETF portfolios.

Policymakers have also warned about liquidity risk spurred by the ETFs market boom. In a report this month, the European Systemic Risk Board warned that market stress could “create first-mover advantages if, for instance, primary markets offer stale prices, while the underlying markets are turning illiquid”. Given the overall concern about leverage, the ETFs market will continue to be scrutinised and more activity from policymakers can be expected. Market players skewed towards passive portfolio strategies should in particular start thinking about the potential implications of this rising scrutiny.