Why the Growth of ETFs Does Not Spell the End of Price Efficiency

KEY TAKEAWAYS

We believe that concerns of decreasing price efficiency due to the growth of ETF investing are overstated.
ETF trading volume exceeds ETF flow by a wide margin: For every $1 flowing into ETFs there has averaged $78 in trading.
This suggests that a significant portion of ETF trading activity is not related to buy-and-hold trades.

Index investing has increased in popularity in recent years, with some of the most widely traded tickers now being index ETFs. For example, SPY, the SPDR S&P 500 ETF Trust, is one of the most traded vehicles in US markets, with an average daily volume of $38.8 billion¹ in 2022. According to the Investment Company Institute, 46% of total assets in US ETFs and mutual funds were held by index funds as of December 2022, a significant increase from 22% in 2012.²

Along with rising popularity have come rising concerns that index investing detracts from price efficiency in financial markets. Efficient markets are the result of buyers and sellers coming together to determine an asset's fair value. The thinking goes that if investors increasingly bypass that process by simply holding a slice of everything in an index, doesn't pricing become a less-informed process? But research from Dimensional has found that not all trading in ETFs is that of passive, buy-and-hold investors.

If more and more investors are buying ETFs to hold for the long term, net flows to ETFs should be similar to the ETF trading volume. We test this in Exhibit 1 by examining the ratio of total annual ETF trading volume to estimated annual net flows for ETFs listed in the US from 1996 to 2022. A ratio close to one would indicate that trading volume corresponds closely to net flows, and therefore that most trading is from buy-and-hold investors.

To the contrary, Exhibit 1 shows the ratio of trading volume to net flows has remained markedly greater than one, at 78 on average over the period and reaching a peak of about 172 in 2011. In other words, for every $1 flowing into ETFs there has averaged $78 in trading. We find that this pattern is not driven by only the largest vehicles—if it were, it might suggest that investors were largely using the most popular ETFs for short-term positioning. Instead, this trend remains similar when excluding the 10 largest ETFs from the sample. These results indicate that a significant portion of ETF trading activity is not related to buy-and-hold trades.

Other motivations for investors—such as making short-term bets on market movements through trading ETFs representing different asset classes, sectors, countries, or investment styles—appear to drive the increased ETF trading activity over time. For example, an investor who in the past might have expressed a bullish opinion on semiconductor sales by buying a handful of technology stocks is able to express this today through the purchase of a technology ETF. Additionally, index funds still account for only 18% of the US stock market, exceeding 14% in actively managed funds but far below the 69% held directly by other investors, such as hedge funds, pension plans, life insurance companies, and individuals.³ In other words, we believe that reports of the death of price efficiency through the growth of ETFs have been greatly exaggerated.

Footnotes

1. Source: Bloomberg

2. Source: 2023 Investment Company Fact Book, produced by the Investment Company Institute, available at https://www.icifactbook.org/pdf/2023-factbook.pdf

3. Investment Company Fact Book 2023, produced by the Investment Company Institute, available at: https://www.icifactbook.org/pdf/2023-factbook.pdf

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