Tom Bailey: the ETF boom may be making the market more efficient

The rise of passive investing means it is cheaper and easier for investors to short sell shares.

There is supposedly a contradiction at the heart of passive investing. The main argument for investing in exchange-traded funds (ETFs) or an index fund, is because individual investors and active managers have such a hard time consistently achieving a return greater than the market average.

There is plenty of data out there demonstrating this. For example, the regularly published SPIVA scorecards from S&P Dow Jones Indices show that in sterling terms, over the past 10 years, more than 90% of US funds underperformed the S&P 500. A similar number of global fund managers underperformed the S&P Global 1200 Index over the same period. While the rate of underperformance for European, UK and emerging market fund managers was somewhat better, most fund managers in these regions still underperformed.

But why is the market so hard for fund managers to beat? The reason usually given is the market’s efficiency. Stocks prices more or less reflect all known or knowable information about the company. Therefore, trying to pre-empt in advance which share will perform better than others starts to look almost impossible. If it was known with any certainty that something will increase the price of a stock in the future, it will already be reflected in the price. This is partly what is meant by market efficiency – or the efficient market hypothesis.

As a result, many argue that investors are often better off buying the entire stock market rather than attempting to pick their own stocks or using a professional fund manager to do the same.  

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But why is the market efficient? According to one popular explanation, it is because the market is composed of skilled professional investors, such as fund managers, with lots of resources and money at stake. These professional investors, in their bid to seek out profitable opportunities, are constantly analysing the market, valuing companies, poring over financial reports and chewing over the wider macro backdrop. On the back of this, they make their buying and selling decisions, which in turn determine stock prices. In aggregate, they are the market.

Due to this, stocks generally reflect all knowable information. There is very little ‘mispricing’, from which profitable opportunities arise and allow active managers to outperform. And so, it is thanks to professional investors being so skilled that the market has become so hard to beat, or ‘efficient’. And, hence, buying the index has become the ‘smart’ option.

But there is a paradox here. The more money invested passively, the less money there is for professional active investors to hunt for mispriced stocks. Therefore, the more money that is funnelled away from active managers to index funds and ETFs, the less efficient the market will be.

Theoretically, this makes sense. But it also works both ways. If markets become less efficient, it should become easier to beat as there will be more mispriced stocks to profit from. Better active manger performance, in theory, will attract more money back to active investment strategies. This, in turn, should make the market more efficient again, for all the reasons outlined above. And with the market once again becoming more efficient, it will become harder to beat, making passive strategies preferable. There is, in theory, a self-correcting mechanism at work here.

However, there is also another angle to the whole question of whether passive investing makes the market less efficient. Through the increase of loanable stocks available to short-sellers, passive funds may actually be making the market more efficient.

Investors who think a stock is overvalued may decide to “short” it. This means borrowing shares of the company in question from a third party. The investor then sells these shares. If the short-selling investor is correct, the stock’s price will eventually start to decline. Following this decline in price, the short-seller buys the stock at its new, lower price and returns it to the third party it borrowed it from, pocketing the difference.

Short-selling is controversial. As the recent GameStop (NYSE:GME) mania showed, many view the practice as inherently immoral, profiting from bad news and misfortune. Some governments have also been known to impose bans on short-selling in times of market volatility. 

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However, many agree that short-selling is an important part of the “price discovery” process of the stock market. The ability of some market participants to go short on a stock helps make sure the stock’s price is incorporating all knowable information and is therefore efficient.

But when an investor decides to go short, there are costs involved. The investor borrows the stock from a third party who must be compensated for lending their stock. As a result, investors pay fees for borrowing stocks. This can be expensive if there is only a limited supply of stocks available to borrow. As always, costs are barriers to entry so, in theory, the higher the cost of short-selling, the less there will be.

And this is where the rise of passive investing comes in. Historically, short sellers would borrow from brokers. However, index fund and ETF providers, being long-term passive holders, are also well-suited to stock lending. This allows the fund house to generate a new income stream, which can potentially be passed on to their investors in the form of lower fees. According to BlackRock, on average, iShares ETFs domiciled in Europe had 11% of their net asset value on loan at the end of 2020.

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As a result, the rise of passive investing means an increase in the amount of loanable shares, which in turn decreases the cost of borrowing for short sellers. This trend has been documented in a 2019 study by Darius Palia and Stanislav Sokolinski, entitled “Passive Asset Management, Securities Lending, and Asset Price.” Similarly, new data just released by Equiland shows that securities lending by ETFs has almost doubled since 2017, owing to the large ETF inflows.

What all this means is that the shift to passive investing has reduced costs and lowered the barriers to investors going short. If short-selling is an integral part of “price discovery”, reduced barriers to going short mean the market has become more efficient – and that’s thanks to the flow of money into passive index funds and ETFs. So, in this sense, passive investing makes the market more efficient.

As Palia and Sokolinski conclude in their paper: “By making short-selling possible, passive investors can complement the information acquisition efforts of active investors who are willing to short sell stocks. As a consequence, markets can exhibit faster price discovery by incorporating negative information into stock prices.”