As the ETF universe continues to expand at a steady pace, a number of critics are voicing concerns over the risk of passive indexing. Nevertheless, ETF investors and proponents should not be so easily swayed.
There are concerns that the growth of passive indexing is distorting markets, reports John Authers for the Financial Times. Specifically, some are wary that market-cap weighted indexing, where funds buy stocks in proportion to their market value, could cause expensive stocks to become even more expensive, fueling a classic investment bubble.
However, BlackRock recently countered these claims, arguing that indexing investing supports vibrant capital markets.
“Index investing provides a number of important benefits,” according to a BlackRock research note. “First, given the diversity of indexes and the breadth of their holdings, index funds provide capital to a very large number of companies across the spectrum of size, geography, and sector. Second, index investors take a long-term perspective on the companies that they hold. In an era where longtermism is a scarcity, these funds provide stability. Third, sponsors of large index funds are actively engaged in investment stewardship. The scale of these funds allows firms to invest more resources in this area. As a result, most large index funds vote their proxies, rather than outsourcing this function to a proxy advisory firm. Finally, index funds democratize access to diversified investment portfolios”
For instance, BlackRock illustrated that correlations between different stocks and between asset classes have diminished somewhat during the years that passive investing has grown in popularity. Consequently, passive investors may still be able to find areas that zig as markets zag, potentially obviating some of the negative effects of a potential downturn.
ETF trading remains low by BlackRock’s estimates. Index-backed funds turn over $460 billion per year or 7% of total assets under management, compared to the $10 trillion or 80% of assets for active funds. Even if asset flows into passive outstrip the competition, the current volume suggest they are not setting prices at the margin.
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ETFs also help contribute to greater market efficiency through price discovery. For instance, international ETFs are trading in U.S. exchanges during hours when the underlying foreign markets are closed. The Greece ETF is a standout example as it managed to trade in the U.S. during the two weeks when Greek markets and banks were closed during the 2015 “Grexit” crisis. Furthermore, the Egypt ETF was still operating as usual after Egypt’s market closed in response to the so-called Arab Spring.
Furthermore, BlackRock pointed out that more fund managers are seeking diversified indexing strategies, which could help assuage the issue of market cap-weighting that leads to overcrowding in the biggest stocks. The growing popularity of smart beta ETFs that track indices screened for fundamental or alternative measures other than market capitalization should help offset some of the worries caused by passive indexing.
For more information on ETFs, visit our ETF 101 category.