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Liquidity, valuations in focus as ETF ownership of S&P 500 surges: BofA-ML

Higher single-stock volatility, valuation distortions and liquidity concerns could grow due to the surge in popularity of exchange-traded funds (ETFs), which now account for more than a third of U.S. ownership of the S&P 500, Bank of America/Merrill Lynch (BofA/ML) said.

The proportion of stocks on the main U.S. benchmark equity index now managed passively has nearly doubled since the 2008 crisis to 37 percent while ETF trading accounts for about a quarter of the daily volume across U.S. exchanges, BofA/ML, said.

ETFs and index-tracking funds offer investors a cheaper way to access financial markets than their "active" fund management peers which aim to beat the benchmark and charge higher fees for doing so.

Steadily rising U.S. equity markets, currently in the ninth year of a bull market, and the proliferation of ETFs that mimic complex quantitative strategies and investment trends and themes at a lower cost, have sparked a rush of inflows into such products as more investors shift to passive investments.

BofA-ML clients have bought a net $160 billion worth of ETFs since 2009 while selling $200 billion worth of single stocks since, the broker said.

The growing influence of ETFs is likely to alter some long-standing fundamentals across financial markets, analysts and investors have said, with the main issues for stock investors revolving around positioning, liquidity and valuation.

The actual shares available for investors to trade, or the true float, "may be grossly overestimated," if the shares held by passive funds, which do not trade in and out of stocks based on fundamentals or events, are excluded.

Vanguard, one of the world's largest asset managers and which manages a roughly $70 billion S&P 500 ETF, now owns 6.8 percent of the top U.S. equity benchmark. The firm owns stakes of more than 10 percent in over 80 stocks in the S&P 500, BofA/ML estimated.