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Explosion in money flowing into ETFs may lead to a market liquidity problem, Bank of America says

Key Points
  • Bank of America Merrill Lynch warns of liquidity problems caused by ETFs.
  • There is now $4 trillion invested in ETFs.
  • "ETF fads can drive massive PE distortions," says the report.
A woman carrying an umbrella walks past the New York Stock Exchange (NYSE) in New York.
John Taggart | Bloomberg | Getty Images

Bank of America rang a warning bell Wednesday regarding all the money that has piled into passive exchange-traded funds.

The bank says the massive popularity of ETFs may be leading us on a road to a liquidity problem. The note issued by Bank of America Merrill Lynch's Global Research department warns "the actual shares available, or true float for S&P 500 stocks, may be grossly overestimated."

That could lead stocks and the overall market to fluctuate more violently, especially to the downside, due to a future event affecting either a single stock, a sector or the market at large.

Passively managed ETFs have become incredibly attractive to investors, allowing them to pick and choose baskets of stocks representing different parts of the market. According to industry groups, more than $4 trillion is now invested in ETFs.

Vanguard is the second-biggest issuer of ETFs, and it now has at least a 5 percent stake in 491 out of the stocks in the S&P 500, according to the report. That's a massive increase from a 5 percent stake in 116 stocks out of the S&P 500 it held in 2010, illustrating the massive growth of the ETF industry.

A banner first half for ETFs

Halftime Report trader Joe Terranova, the chief market strategist for Virtus Investment Partners, which manages $25 billion, said, "The danger is when the market falls. Liquidity will evaporate." It's like having a building with four lines of people coming in through four entrances, but only one exit everyone will have to pile through in the case of an emergency.

Bank of America's note goes on to warn ETF fads "can drive massive PE (price-earnings ratio) distortions." The firm predicts the next big rush will be into "[v]alue ETFs, environmental, social and corporate governance strategies and short-term quant strategies."

The note also advises individual investors to seek out under-owned parts of the market, basically buying stocks before managers of ETFs gobble them up when it comes time to rebalance their funds.

The other side of the coin, however, is that "there will always be a liquidity problem for the markets any time the amount of sellers swamps the amount of buyers," said Halftime Report trader and CEO of Ritholtz Wealth Management Josh Brown.

"ETFs are way more efficient and although there will always be hiccups, the machinery has demonstrated its ability to be extremely durable in times of market stress," Brown said.

The Bank of America note points out that, like it or not, ETFs in the U.S. may still have a long way to go. The bank says almost 70 percent of all assets under management in Japan are passively managed ETFs — more than double the percent of assets in the U.S. Japan's central bank has added to that high percentage because it has also been buying ETFs as part of its plan to help Japan's economy.

Brown downplays overall fears of liquidity concerns here in the U.S., saying, "It's just a fancy way of people complaining that they can't transact at the price they want to."

Watch: GS says ETFs major force behind market

Goldman says there's one major force behind the market's gains this year: ETFs