Industry Updates

Five most important academic papers on ETFs in 2023

Academics examined the rise of ETFs, factors and pricing inefficiency

Theo Andrew

ETFs graph

Academics were once again pondering the rise of ETF's impact on broader financial markets in 2023 as they continue to disrupt their mutual fund counterparts.

While 2023 has possibly been a less testing one than years gone by, passive power, the decline of active mutual funds and trading efficiency were still topics that caught the attention of researchers.

Whether it is the “opportunistic” voting practices of the ‘Big Three’ – BlackRock, Vanguard and State Street Global Advisors (SSGA) – in a bid to increase market share, or whether the rise of passive investing is decreasing expected returns, there was much for the industry to ponder.

Meanwhile, it was hypothesised that active managers were engaging in defensive strategies because of their falling market share, rather than adapting to a new market regime.

With this in mind, ETF Stream has done a round-up of the five most important academic papers on ETFs in 2023.

1. Active managers engage in ‘hopeful fantasising’ over decline, research warns

The decline of active management and the rise of passives has taken up many column inches over the years, but new research suggests active managers are coming up with techniques in a bid to obscure the market for investors.

Research titled, Active fund managers and the rise of Passive investing: Epistemic opportunism in financial markets, accused active managers of engaging in “cognitive dissonance” over their decline instead of proactively finding solutions for their falling market share.

The most prominent techniques include asserting a strong identity, delegitimising others, framing a practice as inaccessible and hopeless fantasising. The research did highlight practical issues facing active managers such as price distortions created by momentum trading by passive funds.

2. The rise of ETFs is damaging future returns, research finds

The explosion of the use of index funds and ETFs by investors and the reduction in the cost of investing could be damaging investor returns, according to a paper titled, Index Funds, Asset Prices and the Welfare of Investors.

The paper analysed the effects of indexing on asset prices and the welfare of investors across the risk and wealth spectrum. While the shift to ETFs creates benefits such as diversification and increased expected at the individual level, on aggregate, expected returns were likely to fall due to the price of a stock rising while firms' earnings remained consistent.

Wealthier investors, the top 1%, who are more likely to take idiosyncratic risks in single stocks were hit the hardest, while the 2-10% are shielded more by taking a diversified approach to investing.

“While the availability of index funds allows small investors to enjoy market returns, at equilibrium, these market returns are lower than those that were enjoyed by investors before index funds became available,” Martin Schmalz, professor of finance and economics at Oxford Saïd, and author of the report said.

3. ‘ETF bubble’ is a ghost story, pricing inefficiency is not, research finds

The growth of passives between 2000 and 2017 was not responsible for inflating market prices, as other academics have claimed, but did increase volatility in markets while decreasing the impact of new information being priced in.

Research, titled Rise of Passive Investing - Effects on Price Level, Market Volatility, and Price Informativeness, found that the shift to passives did not create an “ETF bubble”.

Despite this, the author of the report, Pawel Bednarek of the University of Pennsylvania, found volatility was 10% higher in 2017 than in 2000 owing to “more prevalent misplacing and slower adjustments in prices”, but could not definitively attribute this to the growth of passives.

He did state, however, that volatility increased due to markets being impacted by non-fundamental factors including the rise of passive strategies, meaning “less information is acquired in aggregate” and a “fall in price informativeness”.

4. BlackRock, Vanguard and State Street rely on ‘millennial marketing’ to enhance market share

The ‘Big Three’ of BlackRock, Vanguard and SSGA are largely uninformed about the assets they hold and either vote with management or “opportunistically” to increase their market share.

The research titled,Opportunism in the Shareholder Voting and Engagement of the ‘Big Three’ Investment Advisers to Index Fundsfound the asset managers implement a “millennial marketing strategy” allowing them to potentially acquire “trillions of dollars of assets under management without having to become informed”.

It added it was difficult for the ‘Big Three’ to act in the interest of each end investor and therefore often voted in line with the board of the company. The paper’s author Bernard Sharfman of the RealClearFoundation warned the actions “can only lead to wealth reductions for investors”.

The research recommended allowing investors to express voting preferences such as voting with the asset manager’s recommendations, voting with company management or abstaining altogether.

5. How many factors should investors take seriously?

The explosion in factors risks overwhelming investors but exactly just how much do they need?

A paper by Robeco, Lancaster University Management School and the Technical University of Munich, titled Factor Zoo, found just one in 10 are needed for portfolios to be sufficiently covered, with many others being ‘redundant’.

Studying 153 US equity factors, the research found just 15 factors are needed to capture all available alpha and added iterative factor models beat common academic models containing the same number of factors by selecting alternative value, profitability, investment or momentum factors or including alternative factor style clusters such as seasonality or short-term reversal.

It also highlighted the need to factor innovation, with some newly published factors superseding older factors.

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