“Software is eating the world.”
Venture capitalist Marc Andreessen wrote these words in 2011. From today’s perspective, with companies like Alphabet, Microsoft and Meta dominating the stock markets, Andreessen’s observation seems to have held up.
If BlackRock CEO Larry Fink had made similar comments about exchange-traded funds (ETFs) 11 years ago, he would also seem prescient today.
But despite its phenomenal growth over the past decade, all is not well in ETF land.
ETF skeptics are getting louder, their criticism more pointed. Active managers, who are completely unbiased, by the way, believe that passive investing is distorting the stock market. The efficiency of capital markets may have increased amid greater integration of the global economy, they say, but ETFs are now skewing the pricing efficiency of single securities.
Given these criticisms, what effect has passive investing, including ETFs and mutual funds that track indexes, had on the US stock market?
The rise of ETFs
ETFs are the most successful financial innovation of the last generation. As of October 31, 2021, more than 8,000 ETFs manage nearly $10 trillion in global assets, according to ETFGI research. ETFs are not only staple investment products for retail and professional investors, but also for central banks. For example, the Bank of Japan has acquired majority ownership of Japanese ETFs through its quantitative easing (QE) program, which would have been unimaginable a few years ago.
Of course, there is no free lunch at markets. The success of the ETF industry has come at the expense of actively managed mutual funds. Active funds have consistently lost market share to ETFs and index mutual funds. The trend is unlikely to slow or reverse anytime soon. The only question is what the final ratio between assets and liabilities will be. Conventional estimates predict that passive products will capture at least two-thirds of the market.
The rise of ETFs: US equity flows, in billions
US Stock Ownership
But fear aside, passive products aren’t taking over the entire investment world. They own only a fraction of the total US stock market. Active and passive funds combined own only 28% of US stocks as of 2020, up from 26% in 2010.
Pension funds, hedge funds, insurance companies, family offices and retail investors remain the majority owners of US stocks. Their combined market share, 72%, has barely increased over the past decade. Fund management firms like BlackRock and Vanguard, which manage $10 trillion and $7.2 trillion respectively, don’t have as powerful an influence as popular perception would have us believe.
Liability is not massive: percentage of US market capitalization
Stock trading for ETFs
Most passive products track indices and therefore tend to ignore corporate news. Active fund managers, on the other hand, respond and react to these events, updating their valuation models accordingly. This leads to buy and sell decisions. If passive funds simply track their index against fundamental changes, ETF skeptics argue, aren’t they making fundamentals less relevant and markets less efficient?
This might be true if there were only a few ETFs. But there are thousands of them and they reproduce the behavior of active managers. For example, if a company in the S&P 500 raises its dividend, it won’t matter much to the ETFs that track the index. But it will be important for strategies focused on dividend yield, and demand is likely to increase. The reaction can only happen when the index rebalances, but the point is clear. Fundamentals are important for passive products. As for active ETFs, which have become popular, they get as much attention in the news as active mutual funds.
Critics also maintain that ETFs have begun to dominate US stock trading. But it is important to differentiate between primary and secondary trade. Most ETF activity occurs in the secondary market: the ETF simply changes hands, from one shareholder to another, without affecting the underlying shares.
As a share of total US equity trading, secondary ETF trading has remained nearly constant at 25% since 2011. This is despite thousands of new products and trillions more in assets under management (AUM).
ETF Secondary Trade: Percentage of total US equity trading
What about the primary market activity that occurs when ETF shares are created or redeemed by associated participants? In this case, the underlying shares are bought or sold, so there is a direct impact on the market.
Again, since 2011, as a share of total US equity trading, ETF primary market activity has barely budged. ETFs make up a paltry 5% of that trading.
Participation of ETFs in the main activity of the US stock market
Impact of ETFs through factor investing
Beyond analyzing ETF trading statistics, how can we measure the ETF’s effect on the stock market? Stock correlation and dispersion are standard metrics, but they don’t reveal any consistent trends in the decade since ETFs took off. At times, stocks are more correlated and less dispersed, but this seems cyclical rather than structural.
What about factor investing, which primarily reflects investor behavior? Does this provide any insight? As passive products capture greater market share, index membership becomes more important. Stocks outside of major indexes like the S&P 500 are drawing less interest, which should lead to a decline in valuations and market capitalizations. Positive and negative feedback loops should be stronger.
And indeed, if you look at the value factor in the US, expensive stocks have consistently outperformed financials since 2009. The size factor fared just as poorly, with large caps outperforming small caps.
While it’s easy to blame the supposed demise of value and size factors on the rise of passive investing, that would be premature. After all, between 1982 and 2000, a time of little or no passive investing, the size factor produced negative returns. Value investing also experienced decades of poor performance over the past century.
US Size and Value Factor Performance, Beta-Neutral, Long-Short
While ETFs are great tools for investors, their original underlying purpose has been corrupted.
“Active management has failed. Just buy the index through an ETF.” That was the initial launch of the ETF. And it worked, for a handful of ETFs that track the S&P 500 and other major indexes. But Wall Street is a sales machine and thus launched thousands of ETF products. Investors were drawn away from the first and most valuable use case of the ETF. After all, the optimal portfolio for most investors is a insipid composed of a couple of stock and bond indices.
Today, there are more than 2,000 U.S. stock-focused ETFs and only about 3,000 U.S. stocks. These ETFs cover every strategy imaginable and almost all are active bets.
This is definitely not what the creators of the ETF intended.
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All posts are the opinion of the author. Therefore, they should not be construed as investment advice, nor do the views expressed necessarily reflect the views of the CFA Institute or the author’s employer.
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