ETFs increase efficiency of markets, new study shows

The growth of exchange traded funds has improved the efficiency of stock markets, according to new research that runs counter to some previous claims.

The global ETF industry has ballooned to almost $15tn in assets, a more than fivefold increase in the past decade, according to figures from consultancy ETFGI, with all but $1tn of this in passive, index-tracking funds.

New research from academics from the US, UK and France argues that this surge in passive money has made equity markets more efficient, contradicting some previous research that has found the opposite.

The ongoing academic debate may ultimately influence the thinking of regulators at a time when some on both the left and the right of the political spectrum have raised concerns over the increasing power of the triumvirate of BlackRock, Vanguard and State Street Global Advisors, which dominate the global ETF industry.

The latest academic analysis suggests the growth of ETFs has improved the efficiency of stock pricing at the market level, a concept dubbed “macro-efficiency”, reducing the prevalence of mispricing.

This greater efficiency is most pronounced during periods of volatility, a time when defects in market structure are most likely to be exposed.

In addition, the analysis found the improvement in pricing efficiency was “largely absent” in emerging markets, where uptake of ETFs is typically far lower than in developed markets such as the US and Europe.

Andrew Clare, professor of asset management at London’s Bayes Business School and co-author of the paper, said the work drew on the past findings of late Nobel laureate Paul Samuelson, who found that markets are “micro efficient” but “macro inefficient”, ie, the efficient markets hypothesis works much better for individual stocks than for the wider stock market. Fellow Nobel laureate Robert Shiller was among those who corroborated Samuelson’s findings.

However, Clare and his colleagues found financial markets may have changed since Samuelson made his observations and macro efficiency has increased since the widespread take up of ETFs.

“Our findings have significant implications for investors. In equity markets that are more developed, and hence have higher levels of macro efficiency, a top-down approach to portfolio construction would appear to be increasingly necessary for effective risk management,” said the paper, ETF adoption and equity market macro-efficiency, which is set to be published in The Journal of Portfolio Management.

If so, one question would be why? Widescale ETF adoption may be new but index-based mutual funds have been around for much longer. But Clare believed the two product types are used in different ways — mutual funds are “more of a buy-and-hold type of investment”, while ETFs can be traded on a daily or even intraday basis, he said.

More rapid absorption of information into market-level pricing might also be thought to lead to greater volatility, as stock prices are more likely to rise and fall together in unison, without offsetting movements. However, Clare said the research did not find that.

Instead, he argued that the findings were positive for the ETF industry, unlike some other analyses.

Research by Valentin Haddad, associate professor of finance at UCLA Anderson School of Management and his colleagues in 2022 is one such analysis. It concluded that the rise of passive investing was distorting price signals and pushing up the volatility of the US stock market.

Earlier analysis cited in Clare’s paper argues that rising ETF ownership could lead to mispricing effects, as an increase in commonality of ownership across a market might weaken the link between an earnings announcement and the price of the relevant stock.

In contrast, Clare’s paper concludes that “passive management instruments may not be a source of market inefficiency as others have claimed in the past. Instead, our results suggest that they may improve equity market efficiency.

“ETFs allow investors to manage portfolio exposures to aggregate risks in a more efficient manner than would be the case if these exposures could only be accessed by trading individual stocks.”

Kenneth Lamont, principal of research at Morningstar, agreed with the “sentiment” of the paper, in that “ETFs have been one of the key tools behind the democratisation of finance, allowing all investors to make low-cost, immediate bets on markets [which] has undoubtedly contributed to the increased efficiency of financial markets in recent years”.

However, Lamont argued that the growth of ETFs “has been inextricably linked with the growth of modern financial markets in general. Divining which of the gains in market efficiency can be linked to ETFs and which to the wide range of other evolutions in the financial markets such as improvements in data, the rise of high-frequency electronic trading, improvements in trading infrastructure etc, which have also developed in parallel to ETFs is probably impossible.”

UCLA’s Haddad believed there were “reasons to be somewhat sceptical” about the argument that if people increasingly trade the broad market, rather than individual stocks, that trading becomes more efficient. 

“The ETFs themselves do not try to time the market, it is the flow in and out of them that does so. If we think that these flows are mostly driven by individuals or unsophisticated institutions, it is difficult to expect them to make prices more efficient. Most modern evidence suggests for example that they extrapolate returns, as opposed to being contrarian which would be optimal.” 

Nevertheless, Clare argued that he and his colleagues’ findings meant regulators should welcome the growth of ETFs and “be cautious about restricting their development”.

“There has been a lot of criticism of ETFs and how they are making the world inefficient,” Clare said. “We find the opposite. They are making the market more efficient rather than more inefficient, and more stable.

“It’s a good news story for the ETF industry. It has been pummelled [by critics] on and off for a number of years.”