For years, investors have speculated about the growth of index funds and the effect it has on markets. Specifically, have the flows to index funds affected how markets price securities?
This is a concern for some investors because, they suggest, too much passive money may alter the process of price discovery. One issue with this idea, however, is the conflation of the size of the index fund market with a growth in “passive” investors. Many people assume index fund investors are passive, buy-and-hold types that are in it for the long haul. Trading data suggests otherwise.
As shown in the table below, three index fund ETFs — an S&P 500 ETF, Invesco’s QQQ, and a Russell 2000 fund — each land in the top 10 of highest average daily trade volumes for US-listed equity securities in 2024.
It seems unlikely all this trading is establishing long-term, buy-and-hold positions. Rather, this trade volume suggests investors are using index funds to express views on the market.
Investors might buy the Russell 2000 ETF with a bullish view on small-cap stocks, while selling shares of QQQ may reflect a bearish outlook on large-cap technology stocks.
More mispricing opportunities?
But what if a higher proportion of assets in index funds means fewer “active” investors devoting resources to analysing securities? Perhaps those remaining active investors could exploit an increasing chance of mispriced securities?
If the rise in indexing was producing low-hanging mispricing fruit, it certainly is not showing up in the performance of actively managed mutual funds and exchange traded funds in the US.
As the percentage of index assets has expanded — jumping to 58 per cent from 32 per cent over the past 10 years, according to the Investment Company Institute’s 2024 fact book — the percentage of active equity funds outperforming their benchmarks over rolling three-year periods has not changed by much.
This is illustrated in the graph below and makes it hard to argue that markets are any less effective at incorporating information into prices.
Trading impact
One effect we do see from the popularity of index funds is the cost of turnover borne by their investors. Index providers announce when stocks are added to or deleted from an index, which enables those tracking the index to line up their trades for the moment the hammer drops. The demand this creates to trade at one moment in time affects the price.
Many studies have found that the inflexibility associated with the necessity to match an index’s performance sacrifices net investment return. In our recent study, we found the average cumulative excess return of additions and deletions across 10 indices is 4 per cent during the 20 trading days leading up to reconstitution, with a reversal of minus 5.7 per cent in the following month.
A simple way to avoid this effect is simply to adopt an investment strategy with the flexibility to trade at moments when the buy or sell increases expected return, rather than when someone else decides.
What is a passive or an active investor?
In the 1970s, index funds were born out of the growing realisation that traditional active management too often failed to live up to its outperformance promise. Investing in index funds was a way of expressing a belief in the power of markets.
Fast forward a few decades, and the link between index funds and this embrace of markets is less clear. Not only are large, broad market funds likely being used to time markets, the rise of thematic ETFs — which allow an individual to magnify exposure to everything from millennial investing to petcare services — opens the door further to using index funds as market timing tools.
It is hard to argue that the owner of a three-times-leveraged coffee ETF is a passive investor and, clearly, this is antithetical to the spirit of trusting market prices.
Further blurring the lines, active investing no longer automatically means performing in-depth fundamental research and stockpicking mispriced securities. Non-index strategies can deviate from the market in systematic ways based on rigorous academic research using what market prices tell us, rather than trying to outguess those prices.
In terms of implementation, any strategy not tracking an index is active. But an active strategy based on a belief in markets may be more in the spirit of the original intent behind “passive investing” than many of the index funds saturating the market.
You can think of these definitions in a four-box grid like that illustrated below.
The rising popularity of index-tracking strategies is a characteristic of today’s markets and a reflection of many investors’ preferences, but it is a mistake to assume all index trackers are passive market participants.
This growing trend may affect markets in various ways, but not to the extent that it might prevent investors from achieving their financial goals.
Wes Crill, PhD, is senior investment director and vice-president at Dimensional Fund Advisors
