As a product of the last several years, ETFs’ promise of liquidity has yet to be tested in a major bear market, particularly in less-liquid fields like high yield bonds.

That’s from Howard Marks and it echoes something he’s been saying for years. Namely that an ETF promises intraday liquidity even as in many cases the assets underlying the ETFs are not in fact liquid.

As Marks put it back in 2015:

The ETF can’t be more liquid than the underlying, and we know the underlying can become highly illiquid.

That is the very foundation of my criticism with regard to HY and EM bond ETFs. It is philosophically impossible for something to be more liquid than what it represents and no amount of “volume” in the ETF units is going to change that. It doesn’t matter how “well behaved” the NAV basis is and similarly, it doesn’t matter how “efficient” you imagine the underlying mechanics are. When push comes to shove (and it will), someone, somewhere, is going to have to transact in the underlying bonds and if they aren’t liquid, well then neither is the ETF.

In short, ETFs are funneling retail money into corners of the market where that money has no business being unless it’s overseen by a professional.

But the problems with ETFs (and passive investing more generally) aren’t confined to vehicles that suffer from an inherent liquidity mismatch. ETFs by definition encourage herding and indiscriminate buying. It stands to reason that if the buying is indiscriminate on the way up, the selling will be similarly indiscriminate on the way down.

Indiscriminate capital allocation invariably (indeed, by definition) leads to misallocated capital. It also encourages mindless participation in markets and discourages analysis. Recall this from Goldman:

With the runaway growth of these products we ask if following an index is the optimal allocation for capital.Namely we run an analysis juxtaposing the ROIC v WACC of the S&P 500 by weights of the underlying stocks. We find that it is not.

There appears to be no direct relationship between a company’s ROIC/WACC and its weight in the S&P 500..

ROIC / WACC for the top 10 companies in the S&P 500 (20% of the index), on average, is lower than that of the next 70 companies.

And make no mistake, the active-to-passive shift is becoming more pronounced by the year:

Indeed, as we wrote just a few days ago, we’ve entered what Deutsche Bank aptly calls “uncharted territory in ETF land” with inflows in H1 2017 very nearly outpacing inflows for any other full year on record:

Further, as we’ve documented extensively, we’re getting pretty far afield at this point with regard to what counts as “passive.” The more “focused” these vehicles get on factor-based strategies or worse, on things that are just outright absurd (remember “Long Jesus?” and/or the “Quincy ETF“?), the more managers are charging presumably to justify the selection of securities. That effectively negates one of the main benefits of “passive” investing. Recall what we wrote earlier this month about the new “FANG ETF“: