introduction
“Software is eating the world.”
The enterprise capitalist Marc Andreessen wrote these words back in 2011. From today’s perspective, when firms like Alphabet, Microsoft and Meta dominate the stock markets, Andreessen’s statement seems to have been proven.
If BlackRock CEO Larry Fink had made similar comments about exchange-traded funds (ETFs) eleven years ago, he would also seem prescient today.
But despite the exceptional growth over the past decade, all shouldn’t be well within the ETF space.
ETF skeptics are getting louder and their criticism is becoming increasingly more clear. Active managers – who, by the best way, are completely unbiased – imagine that passive investing distorts the stock market. They say the efficiency of capital markets has increased as the worldwide economy becomes more integrated, but now ETFs distort the pricing efficiency of individual securities.
Given these criticisms, what impact have passive investments, including ETFs and mutual funds that track indexes, had on the U.S. stock market?
The rise of ETFs
ETFs are probably the most successful financial innovation of the last generation. As of: October 31, 2021, According to ETFGI research, greater than 8,000 ETFs worldwide manage nearly $10 trillion in assets. ETFs aren’t only key investment products for personal and skilled investors, but in addition for central banks. For example, the Bank of Japan has acquired majority ownership of Japanese ETFs through its quantitative easing (QE) program, something that might have been unthinkable a couple of years ago.
Of course, there is no such thing as a such thing as a free lunch on the markets. The success of the ETF industry got here on the expense of actively managed investment funds. Active funds have steadily lost market share to ETFs and indexed mutual funds. The trend is unlikely to slow or reverse soon. The only query is what the connection between lively and passive will ultimately seem like. Conventional estimates suggest that passive products will capture no less than two-thirds of the market.
The Rise of ETFs: US Stock Flows in Billions of Dollars
US stock ownership
But scaremongering aside, passive products aren’t taking on the complete investment world. They only own a fraction of the complete US stock market. Combined lively and passive funds own just 28% of U.S. stocks in 2020, down from 26% in 2010.
Pension funds, hedge funds, insurance firms, family offices and retail investors are still the bulk owners of US stocks. Their combined market share – 72% – has barely modified over the past decade. Fund management firms like BlackRock and Vanguard, which manage $10 trillion and $7.2 trillion respectively, don’t have as all-powerful influence as popular opinion would have us imagine.
Passive Is Not Massive: Percentage of US Stock Market Capitalization
Stock trading through ETFs
Most passive products track indices and subsequently are inclined to ignore company news. Active fund managers, however, react to those events and adjust their valuation models accordingly. This leads to buying and selling decisions. If passive funds simply track their index within the face of fundamental changes, ETF skeptics claim, aren’t they making fundamentals less relevant and markets less efficient?
That could possibly be true if there have been only a couple of ETFs. But there are hundreds, they usually mimic the behavior of lively managers. For example, if an S&P 500 company increases its dividend, it doesn’t matter much to the ETFs that track the index. However, it would play a job for dividend-oriented strategies and can likely increase demand for them. While the response may not occur until the index is rebalanced, the purpose is evident. For passive products, fundamentals are essential. And on the subject of lively ETFs which have change into popular, they pay as much attention to the news as lively mutual funds.
Critics also claim that ETFs have begun to dominate U.S. stock trading. However, it will be important to tell apart between primary and secondary trading. Most ETF activity occurs within the secondary market: the ETF simply changes hands and moves from one shareholder to the subsequent without affecting the underlying stocks.
The share of ETF secondary trading in total US equity trading has remained almost constant at 25% since 2011. This is despite hundreds of recent products and trillions more assets under management (AUM).
ETF secondary trading: Percentage of total US stock trading
What in regards to the primary market activity that happens when ETF shares are issued or redeemed by their associated participants? In this case, the underlying stocks are bought or sold, making a direct impact available on the market.
Again, ETF primary market activity has modified little relative to total U.S. stock trading since 2011. ETFs account for a negligible 5% of this trading.
Share of ETFs in primary US stock market activity
The effect of ETFs through factor investing
Beyond analyzing ETF trading statistics, how can we measure the ETF effect on the stock market? Stock correlation and dispersion are standard metrics, but they don’t show consistent trends in the last decade since ETFs took off. Sometimes stocks are more correlated and fewer diversified, but this appears to be more cyclical than structural.
What about factor investing, which primarily reflects investor behavior? Does this provide any insights? The more market share passive products capture, the more essential index membership becomes. Stocks outside of major indices corresponding to the S&P 500 are attracting less interest, which is more likely to result in falling valuations and market capitalizations. Positive and negative feedback loops should change into stronger.
And in truth, if we have a look at the worth consider the United States, expensive stocks have consistently outperformed low-cost stocks since 2009. The size factor also performed poorly, with large caps outperforming small caps.
While it is simple to attribute the supposed decline of value and size aspects to the rise of passive investing, that might be premature. Finally, the scale factor generated negative returns between 1982 and 2000, a period by which there was little to no passive investing. Value investing also experienced poor performance for a long time over the past century.
US Value and Size Factor Performance, Beta-Neutral, Long-Short
More thoughts
Although ETFs are great tools for investors, their original purpose has been distorted.
“Active management has failed. Just buy the index through an ETF.” That was the primary pitch for 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 selling machine and has launched hundreds of ETF products accordingly. Investors were lured away from the ETF’s first and most dear use case. After all, the optimal portfolio for many investors is a boring portfolio consisting of a couple of stock and bond indices.
Today, there are greater than 2,000 equity-focused ETFs within the United States and only about 3,000 U.S. stocks. These ETFs cover every strategy possible and are just about all lively bets.
This is certainly not what the creators of the ETF intended.
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Photo credit: ©Getty Images / jorgelum
