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Has the growing share of index funds and ETFs changed the market dynamics?

I had this discussion with some of my colleagues the other day. I am of the view that when you have a market participant that is only a buyer when stocks rise, and when that market participant is growing its share of the overall market, that will have an impact on markets dynamics. E.g. the more Amazon rises, the more index funds and ETFs will buy. Active funds, value investors, etc might not be potential buyers of Amazon at these levels, and has probably not been for a long time.

However, a colleague of mine disagreed that ETFs and index funds have not changed the market dynamics, and he claims that it is still active funds who sets the price and are the marginal buyers. He says that it does not matter if money flows into index funds and ETFs, because they will have an equal effect on all stocks, i.e. they will proportionately buy the whole index so all stocks will benefit equally.

However, we know from CFA level 3 that this is not the way index fund are run, i.e. they do not replicate the entire index.

Anybody who has any views on this matter? How has the growing share of index funds and ETFs affected market prices and are active investors still the marginal investors and sets the price?

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As far as stocks like Amazon are concerned, there is practically unlimited capacity to short sell the stock. So, any valuation errors from indexing should still be arbitraged away, in theory anyway.

Where indexing could be disruptive to markets is when there is limited liquidity in individual stocks, such as small caps or emerging markets. For instance, if US investors lost confidence in emerging market stocks, they could sell the MSCI EM index in overwhelming volume. If there is not enough liquidity in China or Brazil equity markets to correct for valuation differences, there could be some temporary adverse pricing effects.

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it will have to have a meaningful effect eventually. as passive becomes a larger part of the market, index makers like S&P will become the king makers and companies will do pretty much anything to get in the S&P 500 or DJIA indices.

compare company #500 to #501 in the S&P 500. #500 has ~20% passive investment while #501 has negligible passive investment. that 20% passive makes a big difference to your cost of capital. now let’s assume passive investment triples. passive could become a majority shareholder in all S&P 500 companies and remain negligible for companies 501+. 

i think passive investing will give way to the re-conglomeratization of corporations as it promotes getting as big as you can to drive your cost of capital down. we will certainly see a revival of cross sector acquisitions as intrasector acquisition opportunities dry up.

any company in the index will likely be less volatile over time and will likely be overpriced relative to non-indexed companies.

that said, as passive grows, being in an index will likely result in greater than historical drawdowns for companies in the index as they will become more susceptible to “dumb” capital flows. so it is not all good for the companies in the index and they will still have to act prudently lest they be banished from the index for overlevering or overextending it reach through acquisition.

the market is more complicated than all of the above but i think my view reflects reality well. to sum, passive should boost valuation of the indexed and lower the valuation of the non-indexed. as passive grows, this impact should become more apparent. high passive ownership is not all good though as it makes the bigger companies appear less risky as volatility is depressed in normal times but drawdown should be greater in down times.

your colleagues logic is flawed.. active funds allocate capital to projects that will have the highest return holding risk constant. so an active fund can be benchmark agnostic in order to fund capital projects that are attractive. he is correct, however, with respect to the notion that mutual funds still have more “dry powder” or AUM to employ relative to ETFs, although these figures are converging. holistically, mutual funds are still the main driver in determining asset prices. 

about a year ago, the majority of the trading activity in ETFs were in the secondary markets.. so therefore when an investor purchases into one, they were simply trading the “bundled security” with another investor, not the underlying securities within the ETF.  This would have no affect on the underlying’s price. however because of the ETFs growing popularity, I tend to partially agree with you. In order to service the demand, APs (authorized participant) need to keep the premium/discount within a certain range and when cash is received they must purchase additional fractions of shares. Its purpose it to replicate the market, which can cause companies with high market cap to become inflated artificially. this is actually beneficially for active investors because there is more opportunity to find undervalued securities, however their price can be dislocated for extended periods of time. 

I don’t think that ETFs will be the cause of the next market downturn, but there will be a massive liquidity issue if we do enter into correction.. BOAML produce a good piece on this recently.

you met me at a very strange time in my life

OK, but has any of you more knowledge into how these index funds actually work in practice? When Blackrock gets huge inflows every day, do they buy the entire index or do they only buy the largest companies in it?