ETF or the aporia of Capital Markets

Passive investment and notably ETFs (Passive) have been tremendously successful. They enable investors to gain exposure to an asset class at a lower cost. And because, at least for equities, many managers fail to outperform the index, especially once costs are included, passive investments took massive market share from active management. From the investor standpoint, it is a simple, cost-effective alternative to active management.
However, the bigger picture is a reminder that it cannot be a win-win situation.

Start with the role of the equity market

Equity markets' role isn’t to allow investors to take risks and potentially gain, at least it is not its primary function. Its main role is to induce a better allocation of capital, through the mechanism of price discovery. The obvious issue is that passive investing doesn’t contribute to price discovery or better allocation of capital.

1/ No participation to primary operations

By definition, passive investing will not allocate capital to IPOs or secondary placings. This is an issue that is far from being anecdotal as the primary goal of financial markets is to provide funding to projects.

2/ No participation in pricing discovery

The supposedly most efficient allocation of capital relies on price discovery. Through the confrontation of buy/sell orders, the market de facto assesses the marginal cost of equity between listed companies and provides information on the cost of financing. Here again, passive investing fails to contribute to this mechanism. At best, it merely amplifies, with a latency, the price discovery made by active investors. But, when passive investing becomes dominant (as it is about to be today), it actually is detrimental to that price discovery mechanism. Indeed, because of the latency of passive investment, there is an increased tendency to follow the trend. Any active contrarian view is increasingly risky, especially for short investors.
Let us imagine a world where there is only passive investing in the market. This is an oxymoron as there would be no relative pricing change and all prices would move alongside, going up with net subscriptions and down with net redemptions. There would be no market beyond the spot pricing of liquidity. Of course, the multiplication of thematic ETFs (sector, theme or country) contains that risk. Yet the mechanism remains such that passive investing is detrimental to adequate theoretical price discovery.

3/ Pro cyclical vs Contra cyclical

As discussed above, passive investing is, by definition, trend following. In the case of subscription, it will buy more of shares that have gone up and less of shares that have gone down. Of course, when facing redemption, the fund will also sell more of shares that have gone up and sell less of those that have gone down. But, unfortunately, subscriptions tend to occur in a bull market and redemptions in a bear market, which amplifies the problem.
In all, one can argue that, unlike active management (where at least some investors are contrarian), passive management is rather pro-cyclical, hence increasing the swings in markets, volatility and eventually the cost of capital.

Overall, passive investment is a fantastic tool for investors to gain exposure to various diversified asset classes. However, it inherently poses problems as it creates a classic ‘commons’ problem: it is better to be part of that party while it lasts and destroys the shared common good: efficient markets. Part of the solution lies in creating the conditions for active fund management to better perform and demonstrate its benefits to end investors. We believe that the abundance of competitive research also has its role to play. Recently, asset management as a whole retrenched and focused on cost-cutting rather than value-creating. With undifferentiated performance and still higher costs, such asset managers made the day of passive funds.

The coming changes to MiFID2 regulation regarding research payment will enable a radical shift. As the leading company in independent research in Europe, AlphaValue may be preaching to the choir but enabling an environment where research is thriving is a precondition for active management to regain ground with bold active strategies rather than bland passive. Saying the obvious never hurts.
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