Index Investing Supports Vibrant Capital Markets

This post is based on a publication from BlackRock, Inc.

Index investing has profoundly changed the way investors seek returns, manage risk, and build portfolios. For nearly 50 years, index investment vehicles have lowered costs and simplified access to diversified investments for all investors, from sophisticated institutions to individuals. Technology and data have also transformed the range of investments that can be tracked by an index. Choice now extends beyond traditional equity indexes, which include stocks in proportion to their market-capitalization, to a whole array of more dynamic indexes compiled according to other methodologies. [1] These can be used to create investment products that serve a wide variety of needs—for example, products that track indexes with exposure to specific investment styles such as value or quality stocks.

Change is often disruptive to established norms, however, and there has been a cadence of commentary citing concern about the growth of index investing. Some of the headlines have been arresting, [2] but many of the underlying arguments either are not supported in the data or would benefit from greater clarity and a common language around key concepts, such as asset ownership versus asset management; the size of assets managed by external managers relative to the total market value of investable assets; and shareholder activism versus activist investors. Although the benefits of index investing are widely recognized, these concerns have focused on its market impact. We see two themes emerging.

First, some commentators have sought to examine the role that index investing plays in capital markets. In particular, they ask whether index funds, by which we refer in this post to index mutual funds and exchange traded funds (ETFs), have the potential to distort investment flows, create stock price bubbles, or conversely, exacerbate a decline in market prices. [3]

Second, other commentators have explored index investing, stock ownership, and competition, attributing higher consumer prices, escalating executive compensation, and even aspects of wealth inequality to index investment products. [4] This academic discourse is often referred to as the literature on “common ownership”—a shorthand term for the ownership by a single entity of shares of multiple companies in an industry.

In this post, we outline some of the key elements of the debate around index investing, with the objective of differentiating core concepts and providing a practical perspective. We focus here on index investing in relation to company stocks and the equity markets. [5] We begin by defining the spectrum of investment styles at the center of this debate, from the more active to the more index driven, and put the relative adoption of each style in perspective. We then draw out some of the distinct concepts at play, and address the impact of index investing on the equity markets. Finally, we examine the theories around common ownership, building on our publication entitled “Index Investing and Common Ownership Theories.” [6]

Key Observations

1. Index investing has profoundly changed the way investors seek returns, manage risk, and build portfolios.

  • Index investing has been transformational in providing low cost access to diversified investments for all investors, from institutions to individuals.
  • Technology has extended the range of investments that can be indexed, providing choices beyond the traditional market-capitalization weighted indexes to more dynamic indexes, such as those tracking investment styles and value or quality stocks.
  • Global trends driving the adoption of index investing strategies, include:
    • Growing awareness of the value proposition they offer, in seeking to track, rather than beat, a benchmark index;
    • increased focus on fees and transparency by regulators and investors; and
    • shift in brokerage and advice models that has seen investment advisers increasingly act less as stock or fund selectors, and focus more on building diversified portfolios, often delivered through index funds.

2. Despite its popularity, the relative scale of index investing is still small. Index investing overall represents less than 20% of global equities. Index funds and ETFs together represent just over 12% of the US equity universe, and 7% of the global equity universe. [7]

  • While index investing is currently growing at a faster rate than active strategies, the balance of active and index management is self-regulating.
    • Underperformance by many active strategies has helped increase the appeal of index strategies. If index investing were to grow large enough to affect price discovery, any short term price fluctuations of individual stocks would be used by active managers to improve their performance.
    • Improved active performance would attract flows back into active strategies. Intuitively, the market will continuously adjust to an equilibrium.
  • Further, while differentiating between active and index strategies is often a useful shorthand, in practice the investment landscape is not a binary choice between two styles, but rather a continuum of investment strategies that range from the more active to the more index driven. As a manager of both active and index based investment solutions, we see important and complementary roles for both.

3. The evolution of investment norms is generating an important debate regarding the impact of index investing on investment flows, stock prices, and the efficiency of capital markets.

  • Greater clarity and a common language around core concepts would facilitate a more constructive discussion, including:
    • The difference between asset owners and asset managers;
    • Distinguishing the various forms of index investment products;
    • Threshold reporting and what it can tell us; and
    • The difference between an “active investment manager” and an “activist investor.”

4. Investment flows into different asset classes and sectors are driven by overall asset allocation decisions made by asset owners, not by the appeal of certain products or investment styles.

  • Some commentators are concerned that index funds may drive investment flows into the asset class, sector or region of the moment, only to see a rapid decline when sentiment reverses. [8]
  • In practice, investment products are tools for implementing the individual asset allocation decisions that are made by asset owners. In the absence of index funds, these asset allocation decisions would be executed via an alternative means, such as individual stocks or active funds.
    • Drivers for asset allocation decisions include macroeconomic developments and interest rate policy, not the choice of product.
  • The vast diversity of index benchmarks, strategies, and products means that index assets are not limited to flowing into (or out of) a small set of static strategies, but rather are dispersed widely throughout the investable universe. Moreover, indexes themselves are not static. The stocks included are rebalanced periodically, reflecting the dynamics of the competitive landscapes that they track.

5. Pricing efficiency has benefited from leaps in technology, which continues to bring increasing information and transparency to stock markets. While index investing does play a role, the price discovery process is still dominated by active stock selectors.

  • Price discovery, the process by which new information is incorporated into a stock’s price, is driven by trading activity among buyers and sellers. This takes place at great speed and continues to get faster.
  • Due to its relatively low turnover and small size compared to active strategies, trading driven by index investing plays a small role in the price discovery process for individual stocks.
    • For every $1 of US equity trades driven by index strategies, managers seeking active returns (in excess of benchmark) trade approximately $22. [9]
  • The trading of ETF shares on exchanges in the secondary market does not directly drive buying and selling of the underlying stocks. Purchases and sales of stocks driven by the ETF creation and redemption process account for only 5% of all US stock market trading. [10]
  • However, ETFs contribute to price discovery in two important ways:
    • For example, trading in the US of ETFs invested in international stocks aids price discovery when the domestic markets are closed.
    • Trading of ETFs is a way to express views and contribute to the valuation of sectors, regions or asset classes.

6. Academics continue to argue each side of the debate around index investing and common ownership. Given the early stage of research in this area, policy proposals are premature.

  • Some recent academic literature on common ownership has sought to link asset managers and index investing with negative outcomes for consumers, including higher prices for goods and services. Some authors have gone further in proposing policy measures. However, we believe that these theories rest on some fundamental misconceptions, and do not provide a plausible causal explanation.
  • A growing number of more recent academic papers challenge the assumptions, methodology, and conclusions of the original academic work on this topic, as part of a robust academic dialogue.
  • As with all academic theories, it takes time to test hypotheses and arrive at a conclusion. Given the preliminary stage of this work and the conflicting conclusions, premature policy measures could do more harm than good.

Endnotes

1See BlackRock, Index Investing and Common Ownership Theories, BlackRock Public Policy (Mar. 2017), available at https://www.blackrock.com/corporate/en-de/literature/whitepaper/viewpoint-index-investing-and-common-ownership-theories-engmarch.pdf  at 3 (Common Ownership ViewPoint).(go back)

2See, e.g., Frank Partnoy, Are Index Funds Evil?, The Atlantic (August 2017), available at https://www.theatlantic.com/magazine/archive/2017/09/are-index-funds-evil/534183/; Simone Foxman, Paul Singer Says Passive Investing Is ‘Devouring Capitalism.’, Bloomberg (August 2017), available at https://www.bloomberg.com/news/articles/2017-08-03/singer-s-elliott-hedge-fund-returns-3-5-in-the-first-half; Matt Levine, Are Index Funds Communist?, Bloomberg (August 2016), available at https://www.bloomberg.com/view/articles/2016-08-24/are-index-funds-communist.(go back)

3See, e.g., Chris Flood, Record ETF Inflows Fuel Price Bubble Fears, Financial Times (Aug. 2017), available at https://www.ft.com/content/8720939e-7e82-11e7-9108-edda0bcbc928; Natasha Doff, Traders Fear Hard Landing in Emerging Markets, Bloomberg (July 2017), available at https://www.bloomberg.com/news/articles/2017-07-24/traders-fear-hard-landing-in-emergingmarkets-as-bond-etf-swells; Robin Wigglesworth and Adam Samson, EM worries over swelling influence of ETF flows, Financial Times (Aug. 2017), available at https://www.ft.com/content/6f0350be-8295-11e7-a4ce-15b2513cb3ff.(go back)

4See, e.g., Einer Elhauge, Horizontal Shareholding, 129 Harvard Law Review 1268 (Mar. 10, 2016), available at http://cdn.harvardlawreview.org/wp-content/uploads/2016/03/1267-1317-Online.pdf, discussed on the Forum here.(go back)

5We focus on stock markets because (1) ownership percentages of debt markets by index funds are still de minimis (~5%); (2) debt owners do not customarily have the same governance rights as stock owners; and (3) debt markets trade over-the-counter and not on exchanges, with various levels of pricing transparency ranging from the Trade Reporting and Compliance Engine (TRACE) reporting to “by appointment” or even without report.(go back)

6Common Ownership ViewPoint.(go back)

7Index investing represents less than 20% of global equities (inclusive of assumptions around institutional indexing outside of mutual funds and ETFs), with index funds and ETFs (where no estimates are required as this data is publicly available) representing just over 7% and 12% of the global and US equity universes, respectively.(go back)

8The Business Times, Citi Says Emerging Markets Increasingly Reliant on ETF Flows, The Business Times (Aug. 2017), available at http://www.businesstimes.com.sg/banking-finance/citi-says-emerging-markets-increasingly-reliant-on-etf-flows; Robin Wigglesworth and Adam Samson, EM worries over swelling influence of ETF flows, Financial Times (Aug. 2017), available at https://www.ft.com/content/6f0350be-8295-11e7-a4ce-15b2513cb3ff; Chris Flood, Record ETF inflows fuel price bubble fears, Financial Times (Aug. 2017) available at https://www.ft.com/content/8720939e-7e82-11e7-9108-edda0bcbc928.(go back)

9As shown in Exhibit 9 in this paper, we estimate the total amount of US equity stocks turned over by active mutual funds and index funds, calculated by multiplying relative AUM size by their respective turnover ratios. We estimate that active funds drive greater turnover of US equities than index funds do, showing that active funds clearly dominate stock trading flows.(go back)

10Phil MacKintosh, 5 Reasons ETFs Impact Stocks Less Than You Think, Virtu Financial (formerly known as KCG) Market Commentary: ETF Insights (Feb. 8, 2017), available at https://ptportal.kcg.com/kresearch/do/research/getDownload?attachmentId=4728&username=8FEW5ecT13JTdHAY7Qm0TA (ETF Insights Report). Create/Redeem flow is an average of $8.9 billion per day. This is 11% of all ETF trading but only about 5% of all US stock trading. US stocks traded $190 billion in 2016.(go back)

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The complete publication is available for download here.

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