🔎Are these the final innings of the ETF bubble?
Probably not. But I feel the time has come to protect oneself from getting caught in its aftermath.
You can’t adequately describe this bull market without pointing to the extraordinary level of fiscal deficit spending. The US Treasury is still net spending 6% of GDP every year, a silly amount that used to be unthinkable outside of major recessions. This deficit creates demand for economic growth, household income growth and corporate profit growth. It injects savings into the private sector and it drives investor risk appetite by supplying low risk assets into investor portfolios.
Also, you can’t adequately describe this bull market without pointing to the extraordinary technological innovation associated with large language models and neural networks generally. Commercially scaling this technology is insanely capital intensive. Corporate spending provides a release valve for the fiscal stimulus and as such drives economic growth as well.
The fiscal regime and the technology regime are important and well-understood pillars of this bull market. They are not the only ones though. There is a third pillar. A pillar that gets a decent share of media coverage as well. But also a pillar the true force of which is underappreciated, especially with respect to how it interacts with fiscal deficit spending and the corporate capex binge.
I am talking about the meteoric rise of ETFs which fundamentally changed how markets operate and which will likely make future historians call the 2020s: The Great ETF bubble.
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TLDR Summary
Investing is tough. But there has been one sure thing at least: Buy a diversified equity ETF and you will do fine. Let others do the work and simply get paid for bearing volatility. This principle has created millionaires for decades.
I’m not so sure it’ll continue to work though given how popular this approach has become. US-domiciled mutual equity fund holdings are being converted into ETFs at an annual rate of $1tn! That’s more than the entire annual saving of US households. If this trend continues, there won’t be any mutual equity funds left in ~10 years. Since most ETFs have passive mandates, price discovery will then be only on an army of retail investors and a few surviving hedge funds.
Markets are already feeling dislocations from this trend. Prices feed themselves rather than being fed by business fundamentals. It has all become about Momentum. There are gamma squeezes everywhere because shrewd traders know how to exploit the dumb algos that govern passive investment products.
This also reshapes management decisions for the worse. An entire generation of CEOs doesn’t believe anymore that their main job is to grow earnings and cash flows. Instead, they believe that their primary job is to attract ETF flows through storytelling and more outright forms of market manipulation. Once they have ignited an initial bid, the passive machine drives the infinity bid.
As a result, markets are losing the ability to perform their central function: to direct capital into the ventures with the highest productivity. This will be detrimental to overall economic growth. Investors will have to pay the price for that eventually.
Protection against the incoming storm can only be found outside of the most popular market segments. In assets where the actual sustainable cash generation matters more than the idea of finding a greater fool later.
The dominance of Momentum is driven by the rise of Passive.
In August 2025, I published the article below which I called The Momentum Bubble.
In that article, I linked the brutal outperformance of the Momentum factor to the dominance of passive (or more precisely: primitive algorithmic) investment products.
In contrast to active investing, passive investing is valuation indifferent. It validates any prior price because it simply enters ‘market buy’ orders for every asset weighted by its current market cap. This amplifies mispricing to both upside and downside. Stocks don’t run out of buyers/sellers when they rise/fall too much. Instead, a rising stock automatically gets a larger bid the next day.
As a result, trends become stronger and last longer. Fertile ground for Momentum factor investing. You can simply buy more of what has been working well because you can trust that primitive algos with massive financial firepower do the same thing.
Smart corporate executives are exploiting this. If they create initial demand for their shares through clever marketing, they can tap into an infinite stream of indiscriminate buying from ETFs. The smartest of them even manage to create real competitive advantages in doing so by lowering their cost of capital below that of their peers.
Passive keeps booming.
After gaining popularity for decades, passive strategies surpassed active management in the US for the first time in February 2024.
And they have kept growing since then. The Investment Company Institute (ICI) tracks the flows into US-domiciled investment funds, including both mutual funds and ETFs.
Since January 2024, equity ETFs have received net inflows of more than $2tn while mutual equity funds have lost more than $2tn. Mutual funds are dying. They are being liquidated and converted into ETFs at a monthly rate of $80bn and an annual rate of $1tn!
For reference, this is more than the entire annual saving of US households which currently stands at just $942bn.
The combined equity fund assets in the US mutual fund industry currently stand at $17tn. Hate them for their poor performance if you want. You should still appreciate that this industry has historically been primarily responsible for active investment decisions in public markets to move asset prices to fair levels over time.
If this trend continues, there won’t be a single Dollar invested in a mutual fund on US soil by ~2040. Price discovery will then only happen through retail investors and surviving hedge funds (which are currently collectively at $2tn AuM, a significant amount of which is algo-driven).
Granted, not all ETFs pursue passive investment strategies. There are active managers using ETF structures, such as Cathie Wood for example. But most ETFs are not like that. They simply buy a predetermined basket upon inflows and sell it upon outflows.
Especially levered Passive.
Levered ETFs do the same as standard ETFs, but on steroids. They don’t just buy when they get investor money. They buy every day the underlying basket appreciates and sell when it depreciates. Buy into strength, sell into weakness. Levered ETFs behave like giant call options, dialing their delta up and down with the price of the underlying. The perfect vehicle to bet on Momentum. And since Momentum is working so well, these funds are very popular.
The largest levered ETF is TQQQ 0.00%↑. With $40bn in net assets, it commands a $120bn stock portfolio that is rebalancing based on Momentum every day. The total levered ETF AuM currently stands at almost $200bn, up tenfold from six years ago. Assuming an average leverage of 2x to 3x, this means that levered ETFs are now controlling about $400bn to $600bn stock market value. By the time you read this article, it might already be significantly higher.
The boom is also happening at single stock level. The moment a stock does well, it gets its own levered ETF to fuel its momentum.
Single stock levered ETFs currently have $65bn in AuM. Many of these are 3x levered, meaning that they likely control a total stock value north of $150bn.
Collapsing price discovery
Owning stocks makes money because investors get compensated for bearing volatility. It’s an important investment rule. But it’s also a rule that requires basic market mechanics to be intact. Bearing volatility alone is only a sufficient condition to make money as long as there are other investors who actually do the work and reward companies for positive business inflections or punish them for negative inflections. If you think through passive investing, its freeriding nature becomes really obvious. You piggyback the decisions of others without putting in the effort yourself.
US stock investors haven’t even been exposed to an appropriate amount of volatility lately for their annual returns north of 20%. Based on calendar month returns, the realized volatility of this bull market is hovering just above 10 while the VIX typically trades at 17+. How can anyone claim the recent return of the S&P 500 is a fair compensation for bearing such a small volatility?
Now, the VIX should of course over time trade at a premium to realized volatility just like the insurance premium for your car or home should be above your expected loss. Providing an insurance function needs to have a positive return. Otherwise nobody would offer it. But the amount of that return has been unusually strong for years.
We’re at a point where it’s completely reasonable for most people to treat their S&P 500 shares not as a risky long-term investment, but as a savings account with little risk. People ‘save’ in the S&P 500 just like previous generations have done in savings accounts or Treasuries. Nobody got ahead doing what everyone was doing at that time by the way.
The more the ‘passivation’ of the stock market progresses, the more will a small minority of active investors be overwhelmed by huge amounts of dumb algos that were originally designed to follow the active investors they now dominate. The tail then starts wagging with the dog. Instead of analyzing business fundamentals, investors will start analyzing algorithmic flows and follow them (or try to frontrun them). Chart analysis is so popular these days exactly for that reason. This compromises the market’s ability for price discovery further.
A comprehensive view of the current market regime.
If I had to describe the current market regime based on the three main pillars, I would do it like this:
It all starts with the US Treasury. After 2020, US politicians realized that there is so much demand for US assets domestically and from abroad that they can fix the anemic economic growth of the 2010s through a persistent fiscal impulse. If ageing Americans are too hesitant to spend, then their government can make the spending decision for them.
The economic and political benefits of that approach exceed the political costs (aka inflation). Politicians optimize for votes. People certainly hate inflation. But they like their stock market gains more. At least politicians have concluded that by not addressing the deficit issue.
Given the structure of the US economy, most of that fiscal impulse ends up with US corporations. They are the primary entities which the fiscal impulse compels to spend. AI innovation is happening at exactly the right time to act as a catalyst for that spending. I’m even tempted to assert that the AI capex boom doesn’t just coincide with the fiscal dominance experiment, but is triggered by it. I know that’s a highly speculative and not falsifiable claim. But it’s a plausible one in my opinion.
Most AI spenders don’t have a clear idea how their transformed business will exactly look like once they have ‘AI’-fied everything. They also don’t have a clear expectation of their RoI of their AI investments. But they spend anyway, simply because they can. Demand for compute seems infinite because companies are flush with cash and are willing to spend it.
The passive investment boom acts as an accelerating grease in that machanism. The fiscal impulse gets funneled to companies faster when investors don’t worry much about valuations before they buy. They simply buy the hottest stocks the moment the liquidity provided by the Treasury arrives. These hot stocks enjoy an extremely low cost of capital which encourages them to spend more money to ensure the fiscal impulse remains effective.
How to deal with this?
There are two possible choices for an investor dealing with this market regime: Play or don’t play. You can either join the party, betting that it will continue since there are no clear catalysts in sight to end it. Or you can avoid the best performing stocks, betting that every excess will eventually have to heal through a shock.
It probably won’t surprise you that I consider myself in the second camp. I don’t expect satisfactory long-term returns from assets that are popular among indiscriminate buyers. And I doubt that a ‘greater fool’ investment approach can be sustainable. I don’t want to rely on finding a buyer in the future. I want the stocks/assets I own to work well for me if I never sell them.
That’s why I believe this is the time more than ever to bet on neglected cash generating assets. Assets that provide a service to society that is underappreciated right now. Assets that are in unpopular industries. Assets that are getting removed from the large indices rather than getting added to them. Assets that are cutting or suspending their dividends to preserve cash because investors are not giving them money voluntarily. Assets that are at their 52W lows rather than at new all time highs.
Don’t get me wrong. This is not about buying garbage for the sake of being contrarian. It’s about buying tangible and essential assets the depressed prices of which grant them superior long-term returns from here.
The good thing is that there is tons of them:
Sincerely,
Rene