Are ETFs making markets more efficient?
Now another new study has cast further doubt on claims that the increasing trend towards passive investing is having pernicious effects on the markets. The research, led by Andrew Clare, Professor of Asset Management at Bayes Business School in London, looked specifically at the rising popularity of passive ETFs. The work drew on the past findings of the late Nobel Prize winner Paul Samuelson, who found that markets are “micro efficient” but “macro inefficient” — in other words, individual stocks are efficiently priced but markets as a whole are less so. What Professor Clare and his colleagues found was that ETFs have actually made markets more efficient, not less, and at both a micro and a macro level. What’s more, this greater efficiency, they found, is most pronounced during periods of volatility, just when defects in market structure are most likely to be exposed. “There has been a lot of criticism of ETFs and how they are making the world inefficient,” Clare told the FT . “We find the opposite. They are making the market more efficient rather than more inefficient, and more stable.”A “good news story”
Professor Clare is a “good news story for the ETF industry”. It’s particularly bad news, however, for those who claim that, as more people invest passively, mispricings, and opportunities for active managers to exploit them, increase. It has to be said, other studies on this topic have produced contradictory conclusions. An example is a 2022 study called How Competitive is the Stock Market?, by Valentin Haddad and Paul Huebner from UCLA and Erik Loualiche from the University of Minnesota. That study found that rising demand for passive funds has made the demand for individual stocks approximately 11% more inelastic, leading to less efficient pricing and increased market volatility. Where, then, does the truth lie? Robin Wigglesworth, FT correspondent and author of the book Trillions, which charts the story of the rise of index investing, agrees that more research is needed, but says none of the theories about the structural effects that passive investing may be having on the markets has yet been proved.Index funds don’t drive prices
Most of these theories, Wigglesworth says, come from those directly involved in active fund management and who have a vested interest in trying to stem the flow of assets out of active, and into passive, funds. In many cases, he argues, the theories are based on a flawed understanding of how indexes and index funds operate. For Wigglesworth, the key point to remember is that index funds don’t drive prices up or down; they are price takers, not price makers. It’s a fundamental misconception that, because most of the major indexes are weighted by size, big stocks just become bigger as index funds are constantly forced to chase performance, bidding up prices that are already on the rise. “This completely ignores the basic mechanics of how a cap-weighted index fund actually works,” Wigglesworth says. “It doesn’t need to buy more Apple or Nvidia just because they’ve gone up, as it already owns them… It doesn’t need to buy a single share to remain perfectly in balance.”Implications for investors
So what does all this mean for ordinary investors? Well, the evidence is overwhelming that the vast majority of actively managed funds underperform the market in the long run on a properly cost- and risk-congested basis. Studies also tell us that trying to pick the winners in advance is extremely difficult. That’s mainly because financial markets are very efficient. Simply put, new information is fully and very quickly reflected in prices, which makes it very hard to identify stocks that are either undervalued or overvalued. Studies show that, if anything, markets have become increasingly efficient over time, and, as this latest research from Clare et al. shows, the popularity of indexing may be a contributory factor. In that sense, the case for investing passively — simply capturing the market return cheaply and efficiently — is now even stronger than it was. Even if the likes of Professor Clare and Robin Wigglesworth are wrong, and passive investing is distorting the markets, that is more of a concern to regulators and governments than it is to investors. Yes, it could potentially have an adverse impact on stock prices, but in that case active and passive investors alike would be affected. Why? Because active and passive funds invest in the same stocks, and, in aggregate, active funds have broadly the same weightings as the index. In other words, active funds, collectively, are themselves the index. For now, then, for most of us, this doesn’t appear to be an issue to worry about. Ultimately, as investors, we have to do what’s best for us, and all the evidence currently available points to that being investing in index funds.LET’S TALK
Would you like to find out more about evidence-based investing and how we can build a portfolio that seeks to maximise the returns you can expect to receive for the level of risk you take?
Then why not get in touch? We’d love to talk to you.
