Practical analysis for investment professionals
21 January 2022

Myth-Busting: ETFs Are Eating the World

Introduction

“Software is eating the world.”

The venture capitalist Marc Andreessen wrote these words back 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.

Had BlackRock CEO Larry Fink made similar comments about exchange-traded funds (ETFs) 11 years ago, he likewise would look prescient today.

But despite its phenomenal growth over the last decade, not all is well in ETF land.

Subscribe Button

ETF skeptics are growing louder, their criticisms more pointed. Active managers — who are totally unbiased, by the way — believe passive investing is distorting the stock market. The efficiency of the capital markets may have increased amid greater integration of the global economy, they say, but now ETFs are skewing the pricing efficiency of single securities. 

With these critiques in mind, what effect has passive investing, including ETFs and mutual funds that track indices, had on the US stock market?

The Rise of ETFs

ETFs are the most successful financial innovation of the last generation. As of 31 October 2021, more than 8,000 ETFs manage close to $10 trillion in global assets, according to ETFGI research. ETFs are not just core 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 in the markets. The ETF industry’s success has come at the expense of actively managed mutual funds. Active funds have consistently lost market share to ETFs and indexed mutual funds. The trend is unlikely to slow or reverse anytime soon. The only question is what the ultimate ratio between active and passive will be. Conventional estimates anticipate passive products will capture at least two-thirds of the market.


The Rise of ETFs: US Equity Flows, in US Billions

Chart showing The Rise of ETFs: US Equity Flows, in US Billions
Sources: ICI, FactorResearch

US Stock Ownership

But fearmongering aside, passive products are not taking over the whole investment world. They own only a fraction of the total US stock market. Combined active and passive funds 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 are still the majority owners of US stocks. Their combined market share — 72% — has barely budged over the last decade. Fund management companies like BlackRock and Vanguard, which manage $10 trillion and $7.2 trillion, respectively, are not as all-powerful an influence as popular perception would have us believe.


Passive Is Not Massive: Percentage of US Stock Market Capitalization

Chart showing stock market capitalizations of different types of investors
Sources: ICI, FactorResearch

Stock Trading by ETFs

Most passive products track indices and so tend to ignore corporate news. Active fund managers, on the other hand, respond and react to these events, updating their valuation models accordingly. This results in buying and selling decisions. If passive funds simply track their index in the face of fundamental changes, ETF skeptics contend, aren’t they making fundamentals less relevant and the markets less efficient?

That might be true if there were only a few ETFs. But there are thousands and they replicate the behavior of active managers. For example, if an S&P 500 company increases its dividend, it won’t matter much for the ETFs tracking the index. But it will matter for dividend yield-focused strategies and will likely increase the demand for them. The reaction may only occur when the index is rebalanced, but the point is clear. Fundamentals matter for passive products. As for active ETFs, which have grown popular, they pay as much attention to the news as active mutual funds.

Ad for ETFs and Systemic Risks

Critics also maintain that ETFs have begun to dominate trading in US stocks. But it’s important to differentiate between primary and secondary trading. Most ETF activity occurs in the secondary market: The ETF simply changes hands, moving from one shareholder to the next, without affecting the underlying stocks. 

As a share of total US stock trading, ETF secondary trading has remained almost constant at 25% since 2011. This despite thousands of new products and trillions more in assets under management (AUM).


ETF Secondary Trading: Percentage of Total US Stock Trading

Chart showing ETF Secondary Trading: Percentage of Total US Stock Trading
Source: ICI, FactorResearch

What about the primary market activity that occurs when ETF shares are created or redeemed by the associated participants? In this case, the underlying stocks are bought or sold, so there is a direct market impact.

Again, since 2011, as a share of total US stock trading, ETF primary market activity has barely budged. ETFs account for an insignificant 5% of this trading.


ETFs’ Share of Primary US Stock Market Activity

Chart showing ETFs' Share of Primary US Stock Market Activity
Sources: ICI, FactorResearch

ETFs’ Impact via Factor Investing

Beyond analyzing ETF trading statistics, how else can we measure the ETF 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 started to take off. Sometimes stocks are more correlated and less dispersed, but this seems cyclical rather than structural.

What about factor investing, which primarily reflects investor behavior? Does that yield any insight? As passive products capture greater market share, index membership becomes more important. Stocks outside major indices like the S&P 500 draw less interest, which should lead to decreasing valuations and market capitalizations. Positive and negative feedback loops should become stronger.

Financial Analysts Journal Current Issue Tile

And indeed, if we look at the value factor in the United States, expensive stocks outperformed cheap ones consistently since 2009. The size factor did just as poorly, as large caps outperformed small caps. 

While it’s easy to blame the supposed demise of the value and size factors on the rise of passive investing, that would be premature. After all, between 1982 and 2000, an era of little or no passive investing, the size factor generated negative returns. Value investing also experienced decades of poor performance over the last century.


US Value and Size Factor Performance, Beta-Neutral, Long–Short

Chart showing US Value and Size Factor Performance, Beta-Neutral, Long-Short
Source: FactorResearch

Further Thoughts

Although 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 pitch for the ETF. And it worked — for a handful of ETFs that track the S&P 500 and other major indices. But Wall Street is a sales machine and accordingly launched thousands of ETF products. Investors were lured away from the ETF’s first and most valuable use case. After all, the optimal portfolio for most investors is a bland one composed of a couple of stock and bond indices.

Tile for Puzzles of Inflation, Money, and Debt: Applying the Fiscal Theory of the Price Level

Today, there are more than 2,000 equity-focused ETFs in the United States and only about 3,000 US stocks. These ETFs cover every imaginable strategy and are almost all active bets.

This is definitely not what the ETF’s creators had intended.

For more insights from Nicolas Rabener and the FactorResearch team, sign up for their email newsletter.

If you liked this post, don’t forget to subscribe to the Enterprising Investor.


All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images / jorgelum


Professional Learning for CFA Institute Members

CFA Institute members are empowered to self-determine and self-report professional learning (PL) credits earned, including content on Enterprising Investor. Members can record credits easily using their online PL tracker.

About the Author(s)
Nicolas Rabener

Nicolas Rabener is the managing director of Finominal, which provides quantitative solutions for factor investing. Previously he founded Jackdaw Capital, a quantitative investment manager focused on equity market neutral strategies. Previously, Rabener worked at GIC (Government of Singapore Investment Corporation) focused on real estate across asset classes. He started his career working for Citigroup in investment banking in London and New York. Rabener holds an MS in management from HHL Leipzig Graduate School of Management, is a CAIA charter holder, and enjoys endurance sports (100km Ultramarathon, Mont Blanc, Mount Kilimanjaro).

4 thoughts on “Myth-Busting: ETFs Are Eating the World”

  1. Kirk Cornwell says:

    Another layer of management that Federal Reserve and Treasury policy has provided plenty of money for to date. Are we at a “tipping point” of significance? It seems like a “Sell? Sell to whom?” moment should be just around the corner, but central banks seem to have pumped up (yes, oil factor) sovereign funds enough so the worst that can happen is the transfer of ownership of US corporations to foreign hands. Not a bad idea. I would buy an ETF mimicking, for example, the sovereign wealth of Norway or Dubai.

  2. Tom Nichols says:

    I am not sure about the point of this article.

    ETFs are another, possibly less expensive and more tax – efficient, form of OEFs (Open Ended Funds). Like OEFs, ETFs come in all flavors – index funds and actively managed funds. I have seen more in EFTs than OEFs is factor funds, “rules-based” funds and theme-based funds.

    As an Adviser, I view the ETF proliferation positively. ETFs offer several attractions over OEFs. With ETFs, I don’t have to try and figure which share class is least expensive for the client. ETF management fees tend to be lower than for an equivalent OEF. As with OEFs, some ETF investors will lose, some will profit but with ETFs there are no hidden sales fees or multiple share classes.

  3. Tim Paulin, CFA says:

    Sadly, this article is too simplistic. First, the “Passive is not Massive” conclusion is not supported by the visual. All the chart really tells us is that active and passive funds and ETFs have remained fairly steady at 26-28% of aggregate assets over time. What’s missing is detail on how the 72-74% is invested. The nearly three-quarters of aggregate assets MUST BE comprised to some degree of passive investment – it’s just the packaging (e.g., separate accounts, collective trusts) that’s different from OEFs/ETFs. It’s not clear here but I also wonder if some of the Fund/ETF component ignores what’s inside of the funds (e.g., target date funds that invest passively in equities).

    Second, all the noise about primary and secondary trading is just that…noise. Price-setting of stocks is simply a function of supply and demand. To suggest that only active traders influence price is either simplistic…or disingenuous effort of those trying to downplay the price impact of passive investing. What passive ETFs reflect is a systematically static “package” of multiple stocks. On most days, there is no company-specific news for the vast majority of stocks. But supply and demand for the packages (e.g., SPY – SPDR S&P 500 Index ETF) communicates the aggregate market’s perception of the value of both the package AND its constituents. To test this logic, use a common sense approach…one morning we wake up and S&P 500 ETF sellers massively outweigh buyers. Do we really think that market makers, buyers and sellers of individual constituents of the index look at that information and say to themselves “that’s irrelevant…what do the active managers think”?

  4. Michael Vardas says:

    As was highlighted previously by Tim Paulin, institutional investors who represent the majority of US equity market investment dollar value, hold index funds as their core equity portfolio. The integrity of the article suffers as a result of not highlighting the value of these index holdings as percentage of total US equity market capitalization.

    Index funds and ETFs have led to the democratization of the US equity market and a significant portion of global equity markets, ex-US. John Bogle’s first listed index fund was launched in 1976 and investors have not looked back.

    Index funds are eating the world and the creation of the ETF only accelerated this trend. To paraphrase, “the eating will continue until alpha improves”.

    John Bogle’s 8 rules for investing:

    Select low-cost funds
    Consider carefully the added costs of advice
    Do not overrate past fund performance
    Use past performance to determine consistency and risk
    Beware of stars (as in, star mutual fund managers)
    Beware of asset size
    Don’t own too many funds
    Buy your fund portfolio – and hold it

Leave a Reply to Michael Vardas Cancel reply

Your email address will not be published.



By continuing to use the site, you agree to the use of cookies. more information

The cookie settings on this website are set to "allow cookies" to give you the best browsing experience possible. If you continue to use this website without changing your cookie settings or you click "Accept" below then you are consenting to this.

Close