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May 2018

Index funds and the promotion of efficient capital markets

Critiques of indexing are often based on notion that all ETF users all are monolithic. That's not how it works.

Index funds benefit millions of investors with lower management fees, choice and simplicity, but their popularity makes them targets for regular criticism.

A particularly curious refrain from anti-indexers goes like this: Traditional stock pickers seek out companies with the brightest growth prospects and eschew the ones with the bleakest. Therefore, this wind-up goes, stock-picking facilitates efficient capital allocation, but investing in a diverse basket of index-tracking stocks, does not.

This contention ignores the reality that index funds are a meaningful source of capital for companies to grow their businesses and that index asset managers can still engage with management at companies to foster their long-term growth on behalf of clients.

New research from index provider MSCI, Why index funds promote market efficiency, highlights another reason why the argument falls flat: Many investors using index-tracking exchange traded funds aim to exceed the return of the broad market, and not merely replicate it.

Dimitris Melas, MSCI’s global head of core equity research, X-rayed the aggregate positioning of ETF investors and found that what they own is different from broad U.S. and international equity benchmarks.1

His asset-weighted analysis of more than 1,000 ETFs showed that, for instance, ETF investors were in aggregate subtly overweight dividend-paying and “value” stocks, those deemed to be cheaper than the broader market standard valuation metrics. At the same time, he found that ETF investors had above-market exposure to U.S. energy companies and below-market exposure to international energy stocks.

In other words, investors of passive ETFs are actively allocating capital all over the globe in ways that differ from standard, market-cap-weighted benchmarks.

ETF factor and sector allocations

ETF factor and sector allocations

Asset weighted active FaCS factor exposures and GICS® sector weights of 1,024 as of September 2017. GICS is the global industry classification standard jointly developed by MSCI and Standard & Poor's.


Melas’ assessment is intuitive given that there are nearly 2,000 U.S. ETFs that offer wide variety of market exposures across asset classes and geographies. Sector and thematic equity ETFs allow investors to target specific market corners.2 Similarly, country ETFs can give investors precision cross-border exposures.

What’s more, “smart beta” and factor-based ETFs allow investors to express conviction in persistent, historical drivers of returns including dividend yield, “value” or “momentum.” As Melas points out, factor-based ETFs regularly rebalance, effectively buying or selling stocks based on whether they meet their stated index selection criteria in a way that is “similar to the stock selection process practiced by fundamental active portfolio managers.”

The upshot is that, far from constraining efficient capital allocation, index-tracking ETFs “promote the efficient allocation of capital in the economy,” Melas wrote.

Many critiques of indexing are based on the false notion that all ETF users all are monolithic, buy-and-hold investors that rely on the same market-capitalization-weighted indexes. The reality is that ETF investors make active decisions every time they buy or sell.

Director
ETF Commentator