From Dr. Gerd Kommer
(This post from August 2017 was updated in January 2024.)
Since around 2015, it has been increasingly reported in the media that the market share of index funds and ETFs is “now dangerously high” or could lead to “systemic risk” if it continues to grow. In addition to the claim of a dangerously high market share, a number of other anti-ETF arguments are made. The following three quotes exemplify such criticism:
“ETFs pose enormous risks and in many cases are even a sham” (Rainer Laborenz, Managing Director of Azemos Vermögensmanagement GmbH, Offenburg, in an article on the financial portal Fondsprofessional on July 28, 2017).
“Indexing is a massive threat to the stability of the financial system” (Saker Nusseibeh, CEO of the British fund company Hermes Investment Management in the Financial Times from September 26, 2016)
“The Silent Road to Bondage: Why Passive Investing is Worse than Marxism” (title of a research memo on index funds from the American stock broker firm Sanford Bernstein in August 2016)
In this blog post I will address the 19 most common anti-ETF arguments. Before I do that, I would like to briefly explain what the criticism of ETFs is based on.
Whether you demonize ETFs or not, this ETF can be added to any portfolio: The L&G Gerd Kommer Multifactor Equity UCITS ETF. Find out more >
Most of the criticism of ETFs comes from representatives of the traditional financial industry. Their fee income is threatened by the increasing popularity of low-cost ETFs and classic index funds. Because this is the case, ETFs are often downright hushed up by bank “advisors” in their consultations or – if that is not possible – they are bad-mouthed with sometimes hair-raising arguments such as those expressed in the opening quotes. I address all of these arguments in this blog post.
ETFs are also suboptimal for the traditional media, for financial portals on the Internet and for financial bloggers, because in the long term you can write and publish much less about ETFs than about traditional, i.e. complex and high-priced financial products that are constantly changing due to supposedly ever-changing conditions on the financial markets. As a media person, you can create wonderfully “exciting” stories around this complexity and this wild change, which can be retold in a new and slightly different way every three months. This is how circulation and clicks and thus advertising income are generated. An example are stories about incredibly successful or incredibly unsuccessful investment fund managers. ETFs are not suitable at all or only to a limited extent for this type of useless “infotainment” and harmful “financial pornography”. Anything that is not suitable for your own medium is often criticized.
In addition, many aspects of passive investing with ETFs appear counterintuitive to private investors, i.e. contrary to intuition or common sense. In view of this, criticism of ETFs, even false criticism, finds fertile ground among many private investors.
So much for the context of the ETF criticism. Here are the most common anti-ETF and anti-indexing arguments in brief - each with an assessment from me.
► Argument 1: Indexing's market share is already dangerously high at over 25% and is apparently continuing to rise. The facts: The global market share of passive investing - that's what this is ultimately about - is not 25%, but is currently more like 2% to 5%. The incorrect numbers result from conceptual errors and – related to this – the use of incorrect data bases. In one Blog post from January 2022 let's derive these numbers.
► Argument 2: If everyone invests passively, it will no longer work. This is why passive investing is questionable. The facts: Yes, the advantages of passive investing do indeed assume that not all market participants invest passively. However, exactly the same applies to every of the endless number of active investment strategies that exist worldwide. And nobody is afraid that the strategies could be rendered ineffective by too much imitation. But quite apart from this simple, practical argument, another one is even more serious: the vast majority of human activities - with the exception of breathing and purely mental activities such as thinking - do not work at all, or at least work much worse, when all people do these activities at the same time. This is horribly banal and no one has had a problem with it in the last three thousand years. Nevertheless, test my argument for a few seconds: imagine for a moment any activity, not purely mental, that you carry out in a specific place and at a specific time. Then ask yourself what would happen if all People in your city, in your region, in your state or on this earth would do the same. Then ask yourself why this has never happened before and will never happen. The argument “it only works if everyone doesn’t do it” is doubly absurd. Empirically, the constellation does not occur and theoretically it applies to almost everything that people can do. A business student could write a worthwhile dissertation about why this strange issue is still constantly discussed. Be that as it may, if the correctly calculated global market share of passive investing has risen from currently around 2% to 5% to over 80%, then every passive investor can still consider, based on the facts then available, whether to switch to the active camp from this point on. We assume that this point will not be reached in the next 25 years and probably also in the next 100 years.
► Argument 3: The increasing prevalence of passive investing and indexing has contributed to concentration in the American or global stock market. A few mega-large cap companies (e.g. the ten largest individual stocks such as Apple and Microsoft) are gaining increasing weight in the overall market and dominating the stock market. This is unhealthy and dangerous. The Facts: This oft-heard claim is nonsense. Concentration in the U.S. stock market (and probably other national stock markets as well) was higher than it is today at various points in the 1950s, the 1960s, and the 1970s - well before the invention and widespread use of index funds. The American telecommunications company AT&T had a weight of 13% in the American S&P 500 index in 1960, while Apple only had 6 to 7% in 2023 (that was the maximum value of a single share in the S&P 500 in the past 25 years). The nonsense thesis of the “unprecedented concentration” or “top-heavyness” in the stock markets, which is supposedly triggered by indexing, is based on the ultimately manipulative exclusion of historical data and facts that lie longer than approximately 20 years in the past.
► Argument 4: Passive investors are free riders of active investors. The facts: Yes, they are, just as used car buyers are free riders on the new car market. There are thousands of markets to which the bizarre free rider argument could apply. Seen from this point of view, the majority of all markets and therefore market participants are free riders of another market or other market participants. According to this logic, eBay is a free-rider market, the entire labor market is a free-rider of the public school system, and the Thai tourism market is a free-rider of the commercial aircraft market.
► Argument 5: Actively managed funds can invest money safely in a crash and cushion losses; an ETF has to helplessly follow the index downwards. The facts: Yes, actively managed funds can react to this and adjust their strategy, which an index fund cannot. As a result, the performance of actively managed funds is still worse, even in crisis phases. Passive investing produces statistically higher returns over the long term than active investing, and that specifically includes the downside of the market. At this point, just a single numerical factoid: The year 2008 was the worst year for stocks in the USA after 1932. The S&P 500 index (and therefore also an S&P 500 ETF) lost 37% (in USD) in these 12 months, the average stock fund almost 39%.
► Argument 6: Indexing interferes with the proper functioning of the capital allocation function of financial markets. If there is too much indexing, this economically essential function comes to a standstill. The facts: The trading of stocks and bonds between stock exchange participants is cash flow and profit neutral for the issuers of stocks and bonds (companies and states) - so it does not affect either. The importance of the capital allocation function of the financial markets is therefore greatly overestimated. In fact it is Real economy, which adds capital to companies through the purchase of products and withdraws it (indirectly) through non-purchase, i.e. consumers and buyers in companies are responsible for efficient capital allocation. It is the real economy, not fund managers, that made Apple Inc. the most valuable company in the world and drove Nokia, the former market leader in cell phones, to economic nirvana. In addition, ETFs are predominantly used by active investors as part of market timing in order to direct their capital into the asset classes that supposedly have the best return prospects in the short and medium term. Scientific studies show that the information efficiency of the capital markets has most likely not been reduced by ETFs in recent years.
► Argument 7: Index funds/ETFs contribute to increasing risk in the capital markets. The facts: This argument cannot be proven with numbers. In the ten years from 2009 (since the market share growth of index funds accelerated significantly) to the end of 2021, the measurable risk in the form of volatility in the global capital markets (stocks and bonds) tended to decrease and was below average in a very long-term historical comparison. There can be no doubt that the significant increase in this volatility from the beginning of 2022 was due to the Russia-Ukraine war, not to the very slowly increasing market share of passive investing, which was still moderate worldwide.
► Argument 8: Index funds/ETFs have them ➝ Correlations between individual stocks increases and the benefit of diversification decreases. The facts: Science is divided on this argument, which is very difficult to verify clearly. A large part of the increase in these correlations observed over the last 20 years is probably due to causes other than index funds/ETFs, i.e. to very general developments such as the growing integration of global capital markets (globalization).
► Argument 9: “There is a bubble in indices and ETFs”. This formulation is a verbatim quote that I took from a financial portal discussion forum. Although the statement is ultimately devoid of logic and facts, I include it because it is encountered again and again. With regard to the term “indices” contained therein, this statement could be compared to the meaningless statement: “There is a dangerous bubble in shoeboxes.” ETFs are simply a slim, thin shell or packaging for the content that actually matters: stocks or bonds. Why should there be a rating bubble for a case? The cover is a mere appendage of the contents and this is what matters. ETFs do not create new stocks or bonds or change them, but are simply a simple, transparent “container” for these securities. If you want to talk about overvaluation, then it can logically correctly only refer to the content, i.e. stocks or bonds, not to the thin shell around it. Just like with the shoe box: the box does not create shoes or change them and has a microscopic share in the price of the shoes. Shoeboxes are produced and purchased because they contain shoes, not for their own sake. If there were no boxes, another container would be used for shoe purchases, e.g. B. Sell bags or sell them without a container. All of this also applies in almost the same way to ETFs as containers for stocks and bonds.
► Argument 10: The three largest index fund providers – BlackRock, Vanguard and State Street – hold up to 25% of the voting rights in individual companies. That's a dangerous amount of market power. The facts: Here, the participation rates of legally and economically separate, sharply competing competitors are arbitrarily added up. Viewing the total number as the decisive factor for antitrust objections is absurd, just as absurd as adding up the market shares of Volkswagen, Toyota and Tesla and describing this added sum as a monopolistic danger in the automobile market.
► Argument 11: A collapse of the three largest index fund providers mentioned would endanger the global financial architecture. The facts: Behind this argument lies the ignorance of the fundamental difference between large banks, whose collapse can actually have systemic importance, and the completely different business model of fund companies. Even a 90 percent stock market crash would not damage the assets of the fund companies because these losses would not affect their own assets, but those of the investors. Only the fund companies' income from equity funds would shrink (significantly less that from bond funds). For example, the assets managed by BlackRock in ishares ETFs (BlackRock ETFs) are of course not on BlackRock's balance sheet because they do not belong to BlackRock.
► Argument 12: In a mega-crisis or severe systemic crisis, investments in individual securities are technically safer than investments in ETFs. A direct investor in individual securities would access his property more quickly and safely than would be the case with ETFs (packaged investments). The Facts: (a) In general, this anti-ETF argument is purely theoretical speculation without support from empirical-historical data. Let us assume that by “megacrisis” or “severe systemic crisis” we mean events such as a Third World War, a major war in Western Europe, a major civil war on Western European or North American territory, or a chaotic collapse of the Eurozone. Since there were no such crises in the past relevant to this question, only very limited information can be derived from history. Nevertheless, a look at history helps. The financial product “investment funds” (mutual funds) has existed in the USA for over 90 years and in Europe for a good 60 years. During these nine decades, investment funds have experienced almost every stress test imaginable and have always survived it functioning, including the mega-crisis of the Second World War and several serious market and stock market crises (oil crisis crash from 1973, dot-com crash from 2000, major financial crisis from 2007, Corona crash from February 2020 and the Russia-Ukraine war from February 2022). Index funds as a variant of investment funds have existed for around 50 years, ETFs as a variant of index funds for 30 years - so there can be no question of new, untested forms of investment here. In these 50 or 30 years, to the best of my knowledge and belief, no private investor anywhere in the world has ever suffered damage from the legal and market infrastructure structure of index funds or ETFs, which unfortunately cannot be said for many other investment products, e.g. b. open real estate funds.
(b) Should a stock market shutdown occur in a mega-crisis, as was the case in most Western countries for several years during World War II, it would be indiscriminate every type of listed investment - of course also individual securities. Apart from the fact that in such a situation many non-listed assets and asset classes would probably become completely illiquid (unsellable), e.g. B. unlisted company investments, real estate, life insurance and collector's items. This can be assumed simply because the global banking and payment system would no longer function fully in such a crisis.
(c) ETFs are one of the world's most stringently and closely regulated financial products, more strictly regulated than endowment life and pension insurance, certificates, open-ended real estate funds, closed-end funds and many others, including the operation of bank safe deposit boxes and including unlisted corporate investments. Anyone who sees the legal structure of ETFs as problematic should consequently not invest in any of the investments mentioned, as their legal or “market infrastructure” structures are riskier than that of a normal stock or bond ETF.
(d) Global ETF volume (excluding conventional index funds) accounted for approximately $8,000 billion at the end of 2023. A large part of it is held directly by private investors and by state or private pension funds. Because the sum is so large and because so many private investors (i.e. voters) are affected, it can be assumed that the various governments will do everything they can to keep this market sufficiently functional, even in a serious crisis.
(e) The thesis that is sometimes expressed that proof of ownership of ETF shares is more difficult to provide in or after a mega-crisis or in a single legal dispute (outside a mega-crisis) than for individual securities (stocks, bonds) seems hardly plausible when one realizes that ETF shares and individual securities are traded and managed using the same technical systems. If a stock exchange is closed by the government, individual securities and other financial products are just as affected as ETFs. And what is contained in an ETF at any given time is crystal clear because a public index dictates it.
► Argument 13: ETFs are more liquid than some of the securities in which they invest. This cannot work in a market crisis with drying up liquidity. The facts: The fact that fund shares are in some cases more liquid than the assets in which the fund in question invests is not an ETF-specific fact. It applies to many types of collective investment vehicles, e.g. B. for open and closed real estate funds, Hedge funds, Private equity funds, so-called ABS investments and many funds from institutional investors. With ETFs, this criticism only applies to small niche segments with mini-market shares, such as. B. High-yield bond ETFs, and hardly any ETFs that invest in normal stocks, government bonds and corporate bonds Investment grade rating invest. Furthermore, during a severe market crisis, a direct investor's position in these illiquid securities would most likely be the same as that of a corresponding ETF investor. The higher liquidity of certain ETFs containing such illiquid securities in normal stock market phases (over 90% of the time), relative to the liquidity of the individual securities themselves, must be interpreted as an advantage for investors that exists 90% of the time, but not always.
► Argument 14: The structure of some types of ETFs is risky for investors. The facts: This refers to swap ETFs, so-called leveraged ETFs (Leveraged ETFs) and short ETFs. The facts: The global market share of swap ETFs is around 3% and is falling. The market shares of leveraged ETFs and short ETFs are still significantly smaller. Nobody has to buy these special ETFs, and normal private investors obviously rarely do. Systemic risks cannot arise from these niche products due to their low investment volume.
► Argument 15: ETF securities lending is an obscure, high-risk side business of ETFs and can involve risks that are difficult to assess. The facts: Securities lending may be indiscriminately from everyone Investment funds - active and passive - are practiced, and not only by ETFs, but also by actively managed investment funds, hedge funds, sovereign wealth funds, pension funds and other institutional funds. Securities lending has existed for over 50 years and has never caused any significant damage to private investors in the case of investment funds (in regulatory terms “UCITS funds” or their US counterpart “mutual funds”) - not even in the two major stock market crises after 2000 (I am not aware of any cases of damage at all). In my view, ETFs that engage in securities lending are preferable because they generate a small additional return from securities lending that is in reasonable proportion to the mini-risk taken.
► Argument 16: “With ETF investing you only achieve the market return (only the respective asset class return).” The Facts: This argument is technically and formally correct. Nevertheless, a passive ETF investor statistically has an approximately 90 percent chance of outperforming comparable active investors in terms of returns over a period of five years. Put another way, there is a statistical 90 percent chance for active investors to be below the market return and therefore to miss their outperformance goal. The US financial journalist Tyler Mathisen once wrote: “It’s the paradox of index investing today: Gunning for average is your best shot to finish above average.” [It's the paradox of investing in index funds: aiming for the average is your best chance of ending up above the average.]
► Argument 17: An ETF automatically invests in bad stocks. I don't have this disadvantage with actively managed funds or stock picking. The facts: This objection does not change the fact that the majority of all actively managed funds and do-it-yourself portfolios return worse than equivalent ETFs and the minority that return better cannot be predicted. At least that's how science sees it. The reason: Apparently, these actively managed portfolios do not succeed in avoiding the bad stocks (those that have particularly unattractive returns in a specific time window) with sufficient reliability and/or in having the particularly profitable stocks in the portfolio with a sufficiently high level of accuracy.
► Argument 18: An MSCI World ETF is “top heavy” – (see also argument 3). The USA as a region accounts for over 60% and the ten largest individual positions account for over 15%. This is bad diversification. The facts: Yes, that's true, but anyone who is bothered by this at the portfolio level can easily correct it by using other or additional ETFs as they wish and I don't think that's a bad idea. However, the USA's top-heaviness has given the MSCI World Index e.g. B. helped in terms of returns in the 20 years up to today (October 31, 2022). A lower US weighting would have deteriorated returns over this period.
► Argument 19: “Investing in ETFs on a buy-and-hold basis is boring and unsexy.” The facts: If an investor invests primarily through the lens of entertainment value and what can possibly be achieved with it Bragging Rights [the “right” to brag about something] considered, then he will indeed not like ETFs on a buy-and-hold basis. This type of investor sees stock market investments as a “competition”, a “battle” against the market and against other investors in which they want to assert themselves victorious. Passive ETF investing, as recommended in this book, means the opposite, namely with to invest with the market, not against it. Passive ETFs are Flow, not fight. My compromise suggestion to an investor who thinks ETFs are too boring: Invest 90% of your liquid assets in ETFs on a buy-and-hold basis, and 10% in a small gaming portfolio, so to speak, with which you can live out your sporting financial ambitions.
Conclusion
Most of the ETF criticism is one-sided or false and comes from people with a conflict of interest or journalists who want to use scaremongering to increase circulation and click rates. After all: In some special technical aspects, this criticism has helped to make ETFs even safer and more transparent over the years.
Over the past 30 years, ETFs have easily survived the three extremely tough stress tests mentioned above. In these 30 years there have also been many, many smaller, more specific or local crises on the capital market. As far as I know, no private investor in the world has ever suffered any damage due to the legal structure of ETFs. Over the past 50 years, no financial product has generated greater global benefit for small investors than index funds, including their ETF variant.