The rise of ETFs is damaging future returns, research finds

Is passive power harming investor welfare?

Theo Andrew

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The rise of passive investing is decreasing the expected returns from investing in the stock market, academic research has claimed.

The paper, titled Index Funds, Asset Prices and the Welfare of Investors, found few investors were able to benefit from the low-cost passive investing as more people investing in ETFs boosted asset prices and decreased expected returns of the stock market over time.

Passive investing has become a mainstay over the past few years and the impact on the market has been well documented, with increasing concern over the side effects of the growth.

In 2022, the ‘Big Three’ asset managers – BlackRock, Vanguard and State Street Global Advisors (SSGA) – owned 23% of S&P 500 companies, according to one of the report’s authors Martin Schmalz, professor of finance and economics at Oxford Saïd, with some predicting this could rise to over 37% when taking into account pension funds.

However, this explosion of index funds and ETFs and the subsequent decrease in the cost of investing could actually be harming investor welfare, the report said.

The paper, which analysed the effects of indexing on asset prices and the welfare of investors across the risk and wealth spectrum, found the reduction in welfare increased as the fund becomes cheaper as more people invest.

It argues the presence of cheaper passive funds encourages investors to shift wealth from bonds and stocks into funds such as ETFs to benefit from increased expected returns and diversified risk.

“At the individual level, these shifts are welfare-improving,” Schmalz said. “However, in the aggregate, these shifts increase the demand for stocks, which in turn increases the price of stock. Because firm earnings remain constant, expected returns fall.”

It found the richest investors, who take more idiosyncratic risk by investing heavily in single stocks, were impacted the most, while the 2-10% are more diversified in their approach to investing.

This means, investors whose wealth was in the top 1% benefit little from passive funds due to their position on the risk and wealth spectrum, while investors in the top 2-10% benefit “very substantially”, the research said.

“They shift a great deal of invested wealth into the fund and are sufficiently risk-averse to enjoy the resulting reduction in risk,” Schmalz added.

Meanwhile, investors in the upper-middle-class benefit little due to the reduction in risk balancing out with the rise in equity prices. The remaining investors benefit substantially from passive funds despite their returns being small in absolute terms.

“The availability of index funds tends to increase asset prices and decrease investor welfare, and these effects become greater as the cost of indexing declines,” Schmalz said.

“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.”

The report added welfare loss experienced by investors as a result of lower market returns outweighs the gains they receive from reduced portfolio risk.

“This finding suggests that the policy debate on index funds’ effects on corporate governance and consumer welfare may need to be re-framed,” Schmalz said.


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