Swedroe: ETFs A Double Edged Sword

December 28, 2016

Since their introduction in the mid-1990s, exchange-traded funds have become popular investment vehicles due to their low transaction costs, intraday liquidity and tax efficiency. By mid-2016, they represented roughly 10% of the market capitalization of securities traded on U.S. stock exchanges.

Also by mid-2016, ETFs owned about $1.35 trillion of the U.S. stock market, compared with the approximately $6.8 trillion owned by mutual funds. And ETF daily trading volume exceeded 36% of overall stock market trading volume in the first half of this year.

Itzhak Ben-David, Francesco Franzoni and Rabih Moussawi, authors of the October 2016 paper “Exchange Traded Funds (ETFs),” provide a valuable contribution with their survey of the literature on the impact of ETFs on markets.

In the first part of their paper, they describe how ETFs work and what distinguishes them from other pooled investment vehicles. It serves as a good, short primer for investors not familiar with the creation and redemption process. The authors demonstrate how the redemption/creation process and arbitrage work as two mechanisms to keep ETF prices from diverging far from the value of their underlying securities.

Effects Of Indexing

The second part of the paper describes the rise of passive investment and the role that ETFs play in the passive asset management space, which has been persistently gaining market share from active managers. While there are active ETFs, they constitute less than 2% of AUM in the ETF market.

The authors note that, at least in theory, active management benefits from exploiting the noise in prices created by uninformed retail traders. So, in equilibrium, the remainder of capital is invested in passive funds, and thus the increase in passive investment indicates that arbitrage opportunities shrink or disappear. This serves as an indicator that the market is becoming more efficient.

My co-author Andrew Berkin and I present the evidence supporting this view (as well as provide evidence and logic behind other explanations also leading to the conclusion that markets are getting more efficient) in our book, “The Incredible Shrinking Alpha.”

However, Ben-David, Franzoni and Moussawi note that not all researchers share the view that the rise of passive asset management is an indication of improved market efficiency. Others have warned there are adverse effects to rising indexation, including that indexing can create distortion in securities’ valuations, such as inclusion and deletion effects, the increasing co-movement of securities within an index and higher sensitivity to crashes.


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