Does the rise of ETFs impact market efficiency?

The European ETF industry enjoyed net inflows of €23.1bn over the first five months of 2017. These high inflows once again raised a concern for market observers about potentially lower market efficiency: the constituents of the indices are bought by ETF investors just because they are members of an index, not based on analyses of fundamentals or evaluation of the companies’ business model. In other words, ETF investors may buy stocks, thereby holding up their price, that have a very bad balance sheet or decreasing business that other investors wouldn’t buy because of their fundamentals. In this regard, it can be said that the high inflows into ETFs can have an impact on the efficiency of the respective markets, especially if they are niche markets or segments.

Generally speaking, this concern sounds valid, but a closer look could lead one to a different conclusion. This line of argument could be pertinent for passive investments, but it doesn’t take the other side of the asset management spectrum—active management—into consideration. Active managers can exploit these market inefficiencies to generate outperformance (so-called alpha) compared to the respective market indices. In a regular market environment the transactions by active managers should keep the markets efficient, since they are based on fundamental data and the expectations of the portfolio managers. Some market observers doubt this point, since a number of asset managers have tied their portfolios to a market benchmark and manage their portfolios with restrictions on the tracking error and/or deviations in sectors/regions and securities compared to their index. But on the other hand, the high activity with regard to securities lending, shown in the reporting of ETFs that have implemented lending as a source of additional return in their management process should help keep the markets efficient.

Even though these concerns about market efficiency because of the rise of passive products point to a real threat, it can also be said that possible inefficiencies are arbitraged by active managers and therefore will be only temporary. Nevertheless, a further rise of passive products could lead to lower market efficiency. The question then becomes, when does the passive part of the asset management industry become too large for active managers to be able to maintain efficient markets?

Detlef Glow is head of EMEA Research, Thomson Reuters Lipper

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