From Gerd Kommer and Praval Kapoor
Index funds were invented 52 years ago, ETFs - a variant of index funds - 31 years ago. Since then, passive funds have been criticized. In recent years the volume of this criticism has increased and has now sometimes reached a bizarrely shrill level. This is shown by the following five quotes from publications by indexing critics:
- “Why passive investing is worse than Marxism” – title of a research memo from the American stock trader Sanford Bernstein in August 2016 (source)
- “The love of index funds is terrible for our economy” – headline of an article on the US financial portal MarketWatch from December 10, 2018 (source)
- “Passive investing is a huge power and therefore antitrust problem that can threaten the market economy, perhaps even democracy” – Bert Flossbach, head of the largest bank-independent asset manager in Germany, Storch floss stream, in an interview in February 2018 (source)
- “On a societal basis, indexing is potentially disastrous” – Michael Green, portfolio manager at the American asset manager Simplify Asset Management in an interview in July 2021 (source)
- “I believe passive investing is the most massive misallocation of capital in the history of mankind” – Cathie Wood, American (technology) fund manager in an interview in March 2022 (source)
We have already dealt with the 19 most common anti-indexing (or anti-ETF) arguments in a previous blog post (here). As the blog post at the time shows, most anti-indexing criticism can be easily refuted with a bit of factual logic, with historical data or with evidence from studies by independent scientists or regulators.
In this article we would like to take a closer look at one of these 19 anti-index fund arguments - the one that is behind the “strong” quotes listed above. His refutation takes up a little more space than the other 18 arguments.
In our words, this anti-indexing argument goes something like this:
Index funds (including ETFs) now have a market share of [40%]. Because the proportion of passive investing is so high, it is increasingly weakening the price discovery mechanism of the capital market and thereby undermining the stock exchanges' contribution to the economic capital allocation function.
The percentage of passive market share in square brackets above varies depending on the media article and critic. It typically ranges from 20 to 50 percent. This lack of uniformity alone suggests that calculating the market share of “Passive” is apparently not that easy or that clear.
We will show below that the percentage values in question are dramatically exaggerated. In fact, the global market share of passive investing is closer to three to five percent, perhaps even less than two percent — and that's 50 years after the invention of the first index fund in 1971.
In the rest of this blog post, we will explain how the false “20 to 50 percent” that is repeatedly mentioned in the context of the alleged “ETF bubble” or “indexing bubble” comes about, and why the “less than five percent” figure is probably closer to the truth.
How is “passive investing” even defined?
First, a conceptual clarification that is essential for understanding the following data: “Passive investing” – whose global market share is what we are talking about here – is defined as “investing with broadly diversified index funds (ETFs or classic, non-exchange-traded index funds) on a buy-and-hold basis”.
What is important in this definition is the buy-and-hold condition. The mere use of index funds for investment purposes without buy-and-hold does not represent passive, but active investing. It is estimated that more than half of the approximately 10 trillion (10,000 billion) US dollars that were invested in ETFs worldwide at the end of 2021, especially by institutional investors active be used. The majority of these investors speculate on being able to successfully exploit expected differences in returns between asset classes over time and therefore practice market timing. You can also invest actively using a passive vehicle.
In addition, a significant proportion of the approximately 8,000 ETFs worldwide already represent active investing by design, because the investor wants to use them to consciously and specifically deviate from the “market portfolio”. Only the “market portfolio” (however defined in each individual case) would be “passive investing”. These active ETFs include thematic ETFs, inverse ETFs, leverage ETFs, single-stock ETFs, active ETFs (including the funds of the aforementioned Cathie Wood) and the volume-significant ETF segment factor investing ETFs (also known as “smart beta” in industry jargon). The world's largest provider of securities indices, Standard & Poor's Dow Jones (S&P), wrote on the topic of actively investing with index funds: "Whether it's growth versus value, large versus small, or information technology versus the utilities sector, there's no shortage of opinions on where alpha can be uncovered." [1] At the end of December 2022, a total of 2,227 ETFs were listed on the ETF portal justETF.com. 64% (1,430) of these fell into the “active ETFs” category defined in this way.
The actual market share of passive investing
Before we get to the calculation of the real global market share for passive investing, it should be noted that the German-language media almost exclusively mentions figures for the “US investment fund market” on this aspect. “US investment funds” refers to “public funds,” i.e. funds that may be marketed to normal private investors without regulatory restrictions. [2]
In the USA, this type of fund is referred to as “mutual funds”, in Germany it is referred to as mutual funds, “open-ended investment funds” or “UCITS funds”. The latter is the precise term for regulatory purposes. The global technical term for this category of funds is “Regulated Open Ended Funds” (ROEFs). These include mutual funds and ETFs in the USA, so-called “UCITS funds” in Europe, including ETFs. Index funds are almost always ROEFs.
No Mutual funds, on the other hand, are hedge funds, private equity funds, US pension funds, sovereign wealth funds and many other types of institutional funds, which in total exceed the investment volume of the global mutual fund market. What is crucial here is that in these non-public fund types the passive share is either zero (e.g. in hedge funds or private equity funds) or is at least much lower than in public funds.
Now let’s get to the essential statistics. (If you want to fully understand the information in the following table, you will not be able to avoid reading the table footnotes carefully. If you are only interested in the basic logic of the table, you can skip the footnotes.)
Table: composition and volume of the global Investment market and the estimated global market share of passive investing as of the end of 2021
► All numbers rounded. ► [1] Figures in German trillions. A German trillion (1,000 billion) corresponds to an Anglo-Saxon trillion, not to be confused with an Anglo-Saxon trillion (German billion). ► [2] Data from the ICI Factbook 2022 (see below). ► [3] These figures are estimates from Gerd Kommer GmbH; see also the comments in the running text above. ► [4] The numbers in this column are the result of multiplying the numbers in the two columns to the left of it. ► Sources for the underlying raw data: SIFMA 2022 Capital Markets Fact Book (July 2022), ICI Investment Company Fact Book 2022, Savills plc (real estate), various essays from the IMF (IMF) and BIS Basel. The market cap numbers for precious metals and cryptocurrencies come from other easily accessible sources. ► The asset classes are not included in this table Collectibles (e.g. art) and the value of public infrastructure owned by the state, to the extent that they are not included C or D.
Calculating the sum product of the two columns “Share of global assets” and “Real passive investing share” results in a global market share for passive investing across all asset classes of 4,0%. This value is well below the range of 20 to 50 percent that is repeatedly cited by indexing critics and widely reported in the media and on the Internet.
The reasons for the exaggerated market share figures in the media
What are the technical reasons for the inflated market share numbers we keep seeing?
- It incorrectly assumes that figures for the US investment market are representative of the rest of the world. However, the market share of passive funds outside the US is much smaller. However, exact data does not exist for the “world ex North America”. [3]
- It is directly or indirectly incorrectly assumed that so-called “mutual funds” (in which index products make up a comparatively large share) make up the largest part of the global asset market. In reality, in terms of volume, they represent less than a third of all “investment channels” worldwide.
- There is a false assumption that “investing in an index fund” is the same as “investing passively.” As described above, many, probably the majority, of all ETF investors are active investors because they engage in market timing and/or because they invest in active ETFs.
- It ignores that global investment markets (as shown in the table) are highly integrated. (In the real economy - the production and trade of goods and services - this integration is called globalization.) The global investment markets are integrated across countries within the individual asset classes and of course also between the asset classes, i.e. across them. If an investor finds the expected return on his previous MSCI World ETF investment unattractive, then he can switch to any other asset class that seems more attractive to him at that moment: real estate, commodities, bonds, crypto or whatever. Stocks don't just compete with stocks, they compete with them everyone Alternatives. Against this background, it amounts to meaningless number-crunching to calculate the market share of passive investing in isolation for small, artificially defined islands of one country and one financial product within the global investment market, for example for the artificial island of “US public equity funds”. A simple example to illustrate: In 2021, the share of mutual funds in the entire US stock market was 32%. Active funds made up 64% and index funds 36%. So 68% of the US stock market did not consist of mutual funds. In this non-mutual fund part, the indexing portion is significantly lower than in the mutual fund part. What does significantly lower mean? Nobody knows for sure because these numbers don't exist. What we do know is that for a given stock it doesn't matter whether it is bought by a US equity fund, a German balanced fund, an Australian retail investor or a UK hedge fund - they all operate and compete in the same globally integrated market. Because they do that, his calculation of the liability share only makes sense at a global level and only across asset classes.
But even our 4% market share estimate for the global investment market determined above is probably still too high. Why this is the case becomes clear from the following consideration.
The criticism of the supposedly high market share of passive investing is based on the thesis that passive investing impairs the price discovery mechanism of the capital market and therefore weakens the capital allocation function of the market. (In this sense, a market has the economic function of directing scarce capital to where its economic benefit is highest, i.e. reducing suboptimal investments and waste).
However, only the investor who buys or sells (i.e. trades) makes a contribution to price discovery in a specific market and at a specific time. The bare Hold of an investment (asset) contributes absolutely nothing to price determination in the respective asset market because no price signals (in economist jargon, “scarcity signals”) are sent while simply holding an asset. This applies to every asset market: for stocks, bonds, real estate, raw materials, derivatives, precious metals, foreign currencies, cryptocurrencies, collectibles, etc.
Example: Anyone who bought a residential property in Cologne in 1990 and sold it again in 2022 has only contributed to price determination in the Cologne real estate market exactly twice: in 1990, then not again for 32 years and then again in 2022.
Because simply holding assets has no price discovery effect, the market shares of passive investment vehicles (or passive investing in general) in asset volume are of little relevance to a discussion about price discovery and capital allocation in the market.
The question now arises as to how big that is commercialvolume (distinct from investment volume) of passive investment vehicles in relation to the total trading volume. In other words: What is the market share of passive investment vehicles in trading?
The number of trades in the global capital markets has probably increased every year over the past 70 years. There are three main reasons for this: (a) the growth of the global economy, (b) the parallel expansion of the capital markets following the growth of this real economy and (c) technical progress: trading is becoming easier for everyone and is becoming increasingly cheaper due to falling trading costs.
Because index funds trade their holdings very little by design, their share of all trades globally is microscopically small and may have even fallen over the last 30 years - with the emergence of day trading and high frequency trading in the world of active investing.
We estimate the market share of index funds in global trading volume to be well below two percent.
The Science of Passive Investing's Alleged Harms to Price Discovery
Now that we have a more realistic idea of... real market share of passive investing, the question remains what science has to say about the alleged impairment of the price discovery function by passive investing.
Fortunately, there are numerous serious, data-based studies by independent scientists or regulatory authorities. As far as we survey this literature, it comes to an overall result that could be summarized something like this:
“Our analyzes have not revealed a serious or clear risk from the gradually increasing market share of index funds over the last 30 years, but of course you cannot completely rule out the possibility that one will arise one day.”
This summary result shouldn't surprise anyone because, a good 50 years after the invention of index funds, the market share of passive investing is small in terms of investment volume and tiny in terms of trades.
As an example, at the end of this blog post we will mention some current essays by scientists and regulatory authorities. They are intended for those readers who want to understand the academic discussion on the subject matter discussed for themselves.
Conclusion
For the time being, there is no need to take seriously the criticism that is often presented almost hysterically in the traditional media and on the internet at regulars' tables about the market share of Passive Investing, which is supposedly already too high or will soon be too high.
90% of this criticism comes from representatives of the traditional financial industry with conflicts of interest, such as Cathie Wood, Bert Flossbach, Dirk Müller and others - see the quotes at the beginning of this text. Behind the criticism are not objectively researched facts, but rather envy of the growing success of the cheaper competition index funds & ETFs. This success naturally reduces the fee income of traditional financial service providers.
Financial journalists and internet bloggers like to parrot this shrill scaremongering because it can generate circulation and high click rates.
Against this background, it is not surprising if the passive market share is inflated through unsubstantiated claims, rhetorical tricks, oblique factual logic and the use of unrepresentative figures.
The real global market share of passive investing cannot be quantified with any precision or finality because the data material for the regions outside the USA does not support this. However, we can still assume with a high degree of certainty that the real passive market share globally is currently less than five percent.
If this market share should one day rise from its current low level to 80 percent or more, then every passive investor can still consider, in light of the facts then available, whether they want to switch to the active camp from this point on. We assume that this threshold will not be reached in the next 25 years.
Furthermore, the traditional financial industry has it in its own hands to slow down or reverse the increasing popularity of passive investing. All it would have to do is reduce its high fees, improve its chronic underperformance and stop adding new scandals to its 25-year-long series of bankruptcies and mishaps.
Endnotes
[1] In financial jargon, “alpha” means “outperformance”, i.e. returns that are (or should be) above the correctly measured market return or “passive return”.
[2] The term “investment fund” is a potentially misleading term as it is sometimes used as an umbrella term for all Fund categories are used and sometimes only for the subcategory “mutual funds”.
[3] The German financial media and the German part of the Internet have an unprofessional habit of reproducing US data without pointing out that this data is not necessarily representative of the rest of the world. The typical financial journalist or blogger does this because US data is usually the easiest to find and most prepared.
literature
Anadu, Kenechukwu et al. (2020): “The Shift from Active to Passive Investing: Potential Risks to Financial Stability?”; Federal Reserve Board; Washington, D.C.; June 2022; Internet reference: https://www.federalreserve.gov/econres/feds/the-shift-from-active-to-passive-investing-potential-risks-to-financial-stability.htm
Bundesbank (without author) (2018): “The growing importance of exchange-traded funds in the financial markets”; German Bundesbank; Monthly report October 2018; pp. 83-105
Brogaard, Jonathan et al. (2022): "What moves stock prices? The role of news, noise, and information"; In: The Review of Financial Studies; Volume 35; Issue 9; September 2022; pp. 4341–4386
Coles, Jeffrey et al. (2022): “On index investing”; In: Journal of Financial Economics; Volume 145, Issue 3; September 2022; pp. 665-683
Easley, David et al. (2021): “The Active World of Passive Investing”; In: European Finance Review; August 2021; 25; No. 5; pp. 1433–1471
Ganti, Anu/Craig Lazzara (2022): “Shooting the Messenger”; S&P Dow Jones Indices; research; November 22, 2022; Internet reference: https://www.spglobal.com/spdji/en/research/article/shooting-the-messenger/
Marta, Thomas/Fabrice Riva (2022): "Do ETFs increase the comovements of their underlying assets? Evidence from a switch in ETF replication technique"; Working Paper; Oct 27, 2022; Internet reference: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4079302
Pagano, Marco et al. (2019): “Can ETFs contribute to systemic risk?”; ESRB European Systemic Risk Board – Reports of the Advisory Scientific Committee; No. 9; June 2019; Internet reference: https://www.esrb.europa.eu/pub/pdf/asc/esrb.asc190617_9_canetfscontributesystemicrisk~983ea11870.en.pdf
Sushko, Vladyslav/Grant Turner (2018): “The implications of passive investing for securities markets”; Bank for International Settlements; BIS Quarterly Review, 2018; Internet reference: https://www.bis.org/publ/qtrpdf/r_qt1803j.htm