Here are some recent headlines about the consequences of passive investing:
Japan Central Bank’s ETF Shopping Spree Is Becoming a Worry
Passive Market Share to Overtake Active in the US No Later than 2024
Passive investing boom is creating a ‘frightening’ risk for markets
ETFs are taking over the world, and there’s nothing anyone can do to stop them
Let’s Prevent ETFs from Eating the Economy
What all these headlines have in common is that they are inherently misleading. For instance, the first statement reflects a common misconception that the Bank of Japan (BoJ) owns more than two-thirds of the Japanese stock market. In fact, the BoJ owns 70% of listed ETFs, and only 2.5% of the capitalization of the market—not exactly an eye-catching headline. Understanding the importance of passive investing requires us to get both the numerator (passive AUM) and denominator (total market capitalization) correct, and much press commentary is mistaken about one or both.
Calculated properly, how large is passive investing? S&P DJI’s annual asset survey shows that 15% of the S&P 500®’s capitalization is held in S&P 500 index-based funds. Expanding these numbers to cover mid- and small-caps as well as other index providers, we estimate that 20% of total U.S. market capitalization is held by passive trackers. This estimate excludes the factor indices that underlie “smart beta” ETFs. Factor strategies are not price takers—they trade on fundamental metrics like value or momentum, in much the same way (although at different frequencies) as active managers.
So what does 20% passive market share imply for market efficiency? Not much. It is trading, not asset ownership per se, that sets prices, and passive funds’ share of trading is much less than their share of AUM. Under reasonable assumptions, if index funds’ share of AUM is 20%, their share of total trading would be approximately 5%. Even if index assets rose to 50% of AUM, which is a commonly expressed fear from the active side, the passive share of trading would still be less than 20%. Passive price takers are a long way from controlling the market and causing inefficiencies.
Fifty years ago, 100% of market capitalization was actively managed; the shift to 20% passive, with more possibly to come, surely is one of the most important developments in modern financial history. But it’s important not to confuse means and ends. The shift to passive management has been, and continues to be, driven by the persistent underperformance of active managers. Passive growth is the consequence, not the cause, of active underperformance. To argue otherwise is to misunderstand the most important thing about it.