This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article features Wesley Gray, chief executive officer and chief investment officer of Alpha Architect based in Broomall, Pennsylvania.
One class of financial products that has recently experienced truly explosive growth is exchange-traded funds.
But how does this growth affect the market? Do market prices on the underlying assets get more efficient? Are they more volatile? How is market liquidity affected?
These are difficult questions, and academic researchers are finally getting around to addressing these questions. Lin William Cong and Doug Xu, researchers from the storied finance program at the University of Chicago, tackle some of these kinds of questions in their newest paper, “Rise of Factor Investing: Asset Prices, Informational Efficiency, and Security Design." But before we dig into to this fascinating paper, we’ll cover a quick background of the ETF market and why this paper is an important contribution.
Incredible ETF Growth Rate
While exchange-traded products have been around for more than 25 years, their history over the past decade has fundamentally altered the financial landscape for investors. Consider the chart below (sourced from etf.com), which shows the number of ETFs and their growth of assets under management since 1993:
There are nearly 2,000 exchange-traded products on the market, and the AUM growth is more than $2.4 trillion. Furthermore, according to the Financial Times, ETF assets surpassed hedge fund assets during 2015.
Institutional investors increasingly allocate to ETFs and ETPs. A recent study from Greenwich Associates found that two-thirds of U.S.-based institutional investors allocated to ETFs, with 43% of these investors allocating less than 10% of assets to them.
Today ETFs account for almost one-third of U.S. equity trading volume (for those seeking to learn more, check out Eric Balchunas' book, “The Institutional ETF Toolbox,” which offers an overview of ETFs and how they are used by institutional investors).
Clearly, ETFs are becoming more popular, but this begs the initial question: Why?
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.
How ETF Growth Is Impacting Asset Pricing
We conducted an interview with the authors to get a better grasp on what they felt were the most important ideas spawned from their research. I also spent some time reviewing the theorems derived in the paper. The core findings with respect to ETFs and their effects on asset pricing are as follows:
- Market Efficiency Increases: ETFs, or “composite securities,” should improve overall price efficiency, and the impact is bigger for relatively illiquid assets. However, the authors do make the point that firm-specific news might actually get incorporated into prices more slowly. Ironically, as algo-driven ETFs displace “stock-pickers,” stock-pickers might find that their nuanced information collection abilities could become more valuable.
- Volatility and Correlations Increases: ETFs could increase asset volatility and correlations across baskets that have similar systematic factor exposures. On one hand, this is to be expected if systematic factor exposures are being priced more accurately. On the other hand, portfolio diversification assumptions of the past may not hold into the future, if the diversification benefits across composite portfolios increases.
- Mixed Liquidity and Price Impact Effects: The authors find that transaction costs and liquidity impact might increase for illiquid securities. However, the authors find that overall costs to trade securities driven by systematic factors may decrease when traded via composite securities such as ETFs.
The key insight I gleamed from this new research is that understanding the impact of the enormous rise in ETF popularity is complicated and unclear.
Moreover, when viewing the growth of ETFs, one must understand if we are seeing a net increase in factor investor or simply a shift from mutual funds to ETFs. If the net dollars allocated to composite securities hasn’t really changed, we may see little impact on financial markets.
Of course, if the ETF revolution is truly democratizing and enlarging the tent for factor investors, the implications from Will and Doug’s new paper become more relevant.
Wesley Gray (@alphaarchitect) is the CEO and CIO of Alpha Architect, a quantitative asset manager based near Philadelphia that focuses on delivering focused value and momentum factor exposure via their ETFs (QVAL, IVAL, QMOM and IMOM).