Are ETFs and passive funds making markets less efficient?

John Stepek

Last year, in a now-infamous piece of research, Inigo Fraser-Jenkins at US broker Alliance Bernstein argued that passive investing was worse than Marxism. His thesis was broadly as follows: under capitalism, you have individuals allocating resources to where they are most needed, guided by the profit motive. Under Marxism, you have a central authority allocating resources to where they are most needed, guided primarily by bureaucrats. Under passive investing, no one is making the capital allocation decisions - investors are blindly chasing the biggest companies higher, and starving the rest of capital.

Comparing passive investing to Marxism was obviously a bit of a bid to make headlines - and it worked. But the debate over the underlying argument - that the flood of money into passive investment strategies, and the related proliferation of exchange-traded funds (ETFs) is making the market less efficient - is only raging ever harder as passive investment continues to gain market share from the active management industry.

On the surface, the argument makes sense. Index investors are price insensitive. They aren't bothering to analyse the underlying stocks - they just buy them. At the extreme, if active managers were squeezed out of the market altogether, there would be no one analysing companies or looking for opportunities, and as a result, the market would become ever less efficient.

There's also the argument that the popularity of market-cap weighted indices (where the biggest companies by market value rank highest in the index) has turned passive investing into one big 'momentum' trade - with new money chasing the biggest stocks, and neglecting their undervalued smaller rivals. In other words, passive investors are systematically buying high and selling low, which is not a conventional recipe for investment success.

I robot

Of course, the passive investor's response to these arguments, which emanate largely from active fund managers, is: 'They would say that, wouldn't they?' As Laurence Siegel, director of research at the CFA Institute Research Foundation points out, simply moving money from active funds to passive ones does not change the weightings in the index - the shares in question may now be managed by a robot rather than a human, but the robot still has to do "exactly what the human portfolio managers do in aggregate." In other words, the active managers still do the analysis that shapes the index - the existence of passive funds doesn't change that.

The other problem with the argument that passive funds might damage the capital allocation process is that there's not much evidence of active management resulting in a more efficient market. Bubbles and busts have occurred regularly on the watch of active managers. Indeed, you could equally argue that if anything, competition from passive funds may help to make the market more efficient. This is partly as a result of ETFs and trackers displacing overpriced 'closet tracker' funds (actively-managed funds that spend most of their time 'hugging' the index, in order to avoid career-jeopardising underperformance), and partly a consequence of active managers being forced to think harder about how to differentiate their strategies and demonstrate their 'edge' to investors who increasingly wonder what they're paying high fund fees for.

This is not to say that passive investing has no impact on the market's structure. An argument I have more sympathy with, is the idea that increased convenience and low-cost market access do have an impact on investor psychology, particularly if you then combine that with the central bank 'put' (the idea that the Federal Reserve and other global central banks will consistently act to prevent stock markets from falling too far). So it's probably reasonable to say that the rise of ETFs and passive investing in particular has contributed to today's overvalued markets, simply by reducing the friction involved in the investment process. That lack of friction could also mean that when a crash comes, everyone will run for the exits at once, exacerbating the decline and leaving many overly complacent investors suffering a nasty shock.

Crash, bang wallop

And I fully expect ETFs in one form or another to take some of the blame and the flack when the next stock market crash comes. It's inevitable that they will be involved in some way, because they are now such a significant part of the market. And the general success and popularity of ETFs also makes it more likely that index creators will push the structure too far and create financial products that only demonstrate their flaws in a volatile or falling market, when it's too late.

However, this is nothing new. New and improved financial technologies have played roles in bubbles and busts across history - from the joint stock company during the South Sea bubble, to investment trusts in 1929. This doesn't mean that the innovation itself is flawed - merely the exuberance with which investors embrace it. ETFs and passive funds might not be perfect - but they have a distance to go before they're worse than Marxism.


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