Dispelling the Misconception That ETFs Eat the World

These remarks were first written in 2011 by venture capitalist Marc Andreessen. Andreessen’s statement is still valid in light of the dominance of Google, Microsoft, and Meta in the stock markets today. Similar remarks made by BlackRock CEO Larry Fink on exchange-traded funds (ETFs) eleven years ago would have appeared foresighted today. Yet despite ETF land’s spectacular rise over the past ten years, everything could be better would be better there.

The objections of ETF critics are becoming louder and more penetrating. Passive investment, in the opinion of active managers—who are entirely objective—distorts the stock market. They claim that despite growing global economic connectivity and improved capital market efficiency, ETFs are now distorting the price efficiency of individual assets. What impact has passive investment, such as ETFs and mutual funds that monitor indexes, had on the United States stock market in light of these criticisms?

The Evolution of ETFs ETFs is the financial invention that has had the most success in recent years. According to ETFGI analysis, as of 31 October 2021, upwards of 8,000 ETFs are responsible for managing nearly $10 trillion in worldwide assets. ETFs are essential investment tools for both professional and individual investors, as well as for central banks. For instance, through its quantitative easing (QE) initiative, the Bank of Japan has gained a significant share of Japanese ETFs, which was unthinkable just a few years ago.
Of course, there are costs associated with using the markets. The active management mutual fund business has suffered due to the development of the ETF sector. Active funds have continually decreased in popularity to ETFs and index mutual funds. It is doubtful that the trend will soon slow down or turn around. The only unknown is what will ultimately be the split between active and passive. According to conventional estimations, passive goods should account for at least two – third of the market.

Stock Ownership of the US

Notwithstanding the scare tactics, dormant products are not consuming the whole investing industry. They hold only a tiny portion of the American stock market. Just 28% of US equities are collectively held by active and passive funds as of 2020, up from 26% in 2010. Retirement funds, hedge funds, insurance firms, private equity, and retail investors still hold most American equities. Its total market share, 72%, has mostly stayed the same in the past ten years. Contrary to what the general public would have us think, fund management organizations like BlackRock and Vanguard, which oversee $10 trillion and $7.2 trillion, correspondingly, are only some-powerful influences.

ETF stock trading

Most passive products follow indexes; therefore, they often disregard company news. On the other hand, active fund managers react to these occurrences and update their valuation models in response. This leads to decisions about purchasing and selling. ETF detractors argue that passive funds, which merely follow their benchmark in the face of fundamental shifts, aren’t improving markets’ efficiency or making fundamentals more critical.

If there were just a few ETFs, then it may be accurate. Yet there are hundreds, and they mirror the behavior of active management. For the ETFs following the index, whether an S&P 500 business raises its dividend won’t matter much. Nonetheless, it will be significant for rewards yield-focused strategies and probably result in more demand for them. The idea is valid even though the reaction could only happen after the index is rebalanced. Basics are essential for passive goods. Active ETFs that have gained popularity follow the news just as closely as active mutual funds.

According to critics, ETFs have started taking over trading in American equities. Yet, there should be a distinction between primary and secondary transactions. Most ETF activity occurs in the secondary market, where the ETF transfers ownership from one stakeholder to another without impacting the underlying equities. ETF secondary trade has remained steady at 25% of all US stock trading since 2011. This is despite the hundreds of new goods and the additional billions of assets managed (AUM).
What about the principal market activity when connected participants issue or redeem ETF shares? There is a direct market effect in this instance since the underlying equities are bought or sold. Similarly, since 2011, ETF’s main market activity has remained the same as a percentage of all US stock trading. Just 5% of this trade is made up of ETFs.

Effect of Factor Investing with ETFs

What other methods can we gauge the impact of ETFs on the share market besides looking at trade information for ETFs? Standard indicators like stock correlations and dispersion have not shown any consistent changes in the decade after the rise of ETFs. When equities are less distributed and more connected, they appear cyclical instead of structural.

What about investing in factors that mostly mirror investor behavior? Does that provide any answers? Index participation becomes increasingly significant as passive goods increase their market dominance. Less interest in stocks outside effective indexes like the S&P 500 should result in declining values and market capitalizations. Feedback loops, both positive and negative, ought to get stronger.

And indeed, since 2009, if we examine the appropriate measures in the U. S., expensive equities have consistently beaten inexpensive ones. Although large caps outscored tiny caps, the size factor also fared poorly. It would be premature to attribute the alleged decline of the size and value variables to the emergence of passive investment, despite how simple it may seem. The size factor produced negative returns from 1982 to 2000, when the passive investment was minimal. Value investment has also had decades of underwhelming returns throughout the past century.

Other Aspects

ETFs are excellent tools for investors, but their primary intent has yet to be compromised.

Active management could be more effective. Just purchase an ETF that tracks the index. That was the ETF’s original sales pitch. And for a small number of ETFs that followed the S&P 500 and other significant benchmarks, it was successful. Yet Wall Street is indeed a sales engine, so numerous ETF products were introduced. The ETF’s most advantageous and first use case was diverted from investors. After all, the best portfolio for most investors is a simple one comprising a few stock and bond indexes.

There are over 2,000 equity-focused ETFs and roughly 3,000 American stocks in the country. These ETFs are virtually all active bets and cover every conceivable betting strategy. Certainly not what the designers of the ETF meant, this.