How ETFs Are Impacting Asset Pricing

November 30, 2016

Passive Investing Correlation To ETF Growth

The conventional wisdom suggests that the huge increase in the use of ETFs is closely related to the passive investing revolution. Everyone knows about Vanguard, and Jack Bogle, who pioneered the use of passive mutual funds in the 1970s. While passive investing is not a panacea (here is a recent Wall Street Journal post that describes why passive is not a silver bullet), it has undoubtedly been a boon for investors generally.

And the trends are clear. "Composite securities," such as Vanguard's passive mutual funds that tracked large liquid indexes, have been taking share from active managers fairly steadily. The chart below (from a Robert Stambaugh paper) shows trends in the active allocations for mutual funds and institutions over the past several decades:

 

 

The trend toward passive seems consistent with the growth of ETFs and ETPs observed above.

So is the ETF revolution just one big move to passive?

Factor Investing To Drive Leg Up In Growth

The move to ETFs is not entirely driven by a move to passive investing. Even as Vanguard was receiving significant passive flows, various active/passive hybrids, which did more than just track indexes, began to get attention.

For instance, "smart beta" (also going by the names "strategic beta," "alternative indexing" and "enhanced indexing") represented strategies for reconfiguring cap-weighted index funds in ways to offer exposure to systematic investment factors. Today there are thousands of composite products to choose from, allowing exposure to virtually any investment theme you could dream up.

Buyer beware, however, as the emergence of numerous factor-based fund strategies creates an information overload problem. Differentiating among passive, closet-indexers and active highly active factor strategies is nontrivial, but important as per the research on the subject.

But how does the emergence of numerous “composite securities,” many of which are not purely passive, affect the market? Cong and Xu provide some answers in their new paper. The authors explore some important fundamental questions related to trading and the pricing of the underlying assets that make up composite securities. Unfortunately, the source paper is extremely dense and filled with math equations, but the key insights are intuitive.

 

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