ETFs and Efficient Markets

ETF Trends

Exchange traded funds have been under the microscope lately as market inefficiencies have been pegged to these tools. The recent growth of the industry has coincided with some malfunctions in the market, but is this coincidence?

Larry Swedroe for MoneyWatch reports that some of the major negative points that have been circulated about ETFs by active managers include the following: ETFs are making the market less efficient as they buy and sell stocks despite any valuations, and some stocks can be mispriced; over diversification and tracking indices is a foolish way to go about investing and superior long term returns are a product of intellectual courage and each day the mood can change and influence the index.

Evidence that supports the above claims is non-existent. The bottom line is that more serious market inefficiencies would be more prevalent if this were true. ETF growth has been multiplying over the years, with about $1.5 trillion in assets under management. We would be witnessing more in-efficiencies and problems with the stock market on this merit alone. [Are ETFs to Blame for Dwindling Stock Trading Volume?]

In fact, the Standard & Poor’s Indices Versus Active scorecard shows us evidence that there is not an increase in the number of active managers that are beating any benchmarks, reports Swedroe. [Trading Disruptions Underline Importance of ETF Market Makers]

“As we would expect, the performance tends to worsen when we look at longer periods. This is because the typically higher expense ratios of active funds become a greater burden over time. For the past three-year and five-year periods, 86 percent and 75 percent of large-cap funds underperformed, 80 percent and 90 percent of mid-cap funds underperformed, and 67 percent and 83 percent of small-cap funds underperformed, respectively. And there were no asset classes where a majority of active managers outperformed,” Swedroe wrote in a previous article. [ETFs Endure Knight Glitch Better Than 2010 Flash Crash]

The most studied debate in the investing world is the active versus passive investing matter. Evidence does support the notion that passive management, or those funds that passively track a benchmark, is a strategy that can outperform that of active management. There is no evidence suggesting that active managers, as a collective whole, add any value to a portfolio. [Nasdaq Proposes ETF Trading System]

Tisha Guerrero contributed to this article.

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