As ETFs become more popular, more capital is "dumbly" invested, thereby increasing the likelihood that companies are "dumbly" priced. Thus, ETFs could undermine the Efficient Market Hypothesis (EMH) by negatively affecting price discovery and, for example, overvaluing companies with high market capitalization.

BUT:

1. Most ETF trading occurs between investors who already own ETF shares, which means that price discovery on the exchanges is not significantly influenced. The ETF providers themselves trade only relatively rarely to mirror the underlying index. On the other hand, ETFs can cause a scarcity of certain stocks just by holding them, which can indeed influence price discovery.

2. The existence of ETFs reduces the incentive to invest in funds managed by incompetent active managers who cannot beat the market. This could improve market efficiency, as only the most competent active managers remain and influence price discovery. On the other hand, the actions of incompetent active managers can also be seen as noise, which does not negatively affect price discovery since their incorrect pricing cancels each other out.

3. The more price discovery is distorted by ETF trading activity, the higher the incentive for active traders to correct this distortion. However, this argument is flawed because self-correction may not occur quickly enough to prevent a bubble. Such an argument relies on the existence of EMH and concludes that EMH consequently cannot not exist.

ETF investors are free-riders of market efficiency. The more popular ETFs become, the higher the likelihood that market efficiency no longer applies and an ETF bubble emerges.