Reading 2022-04-26


Notes from reading

Prices are set by trading. Each trade is a vote for the price going up or down. The aggregation of all of these votes is the current price which is the market's best guess at the actual value of a company.

A 2017 study from BlackRock found that only 7.4% of a global market was owned by index funds. Index ownership of the market has increased but it is still relatively small.

Assets under management do not set prices. Trading sets prices. The relevant question is not how much of the market is indexed, but how much of the trading index funds are doing.

  • The majority of ETF trading is happening on the secondary market. That is ETF unit holders trading with each other, without touching the underlying securities
  • It is only when there are deviations between the price of the ETF and the value of the underlying securities, which you can think about as excess supply or demand for the ETF units, that the authorized participant will create or redeem ETF units. Unlike secondary market transactions, the process of creating and redeeming ETF units requires trading in the underlying stocks
  • In a 2018 paper titled, Setting the record straight: Truths about indexing, Vanguard demonstrated that the vast majority of equity ETF trading, 94% on average, is done on the secondary market
  • In their 2017 paper, Index Investing Supports Vibrant Capital Markets, BlackRock presented a similar figure. Showing that ETF creation makes up a tiny fraction of US equity dollar trading volume.

If index funds are not doing the majority of trading, then it is still the active managers dominating price discovery.

The Vanguard's 2018 paper titled, Setting the record straight: Truths about indexing, reports that only 5% of total trading activity in the stock market is executed by index funds, while active mandates are executing the rest. BlackRock similarly estimates that for every $1 of stock trades placed by index funds, there are $22 of trades placed by active managers. Hence, price discovery, which is driven by trading, is still dominated by active managers.

In their 1980 paper on the impossibility of informationally efficient markets, Sanford Grossman and Joseph Stiglitz explained that the market must exist in an equilibrium state. If the market were perfectly efficient, everyone would index, which would lead to price distortions. Therefore, as soon as we reach what we might call "peak index", where the market stops pricing assets correctly, the active manageable profit by getting prices back in line, driving more people to invest actively. This equilibrium state is known as the Grossman Stiglitz paradox.

The perspective of the 2005 paper, Disagreement Tastes and Asset Prices by Eugene Fama and Ken French, suggest that

  • the pressure of indexing may be pushing bad active managers out, leaving only the skilled managers which should make the market more efficient

A 2019 paper titled, Passive Asset Management, Securities Lending, and Asset Prices, by Darius Palia and Stanislav Sokolinski, suggested that

  • the growth of index assets has reduced the cost of shorting
  • Index funds passively hold large amounts of securities, which allows them to lend these securities out to short sellers. This is a key revenue source for index funds and it is one of the reasons that their fees are so low
  • the competence for securities lending revenue has decreased the cost of short selling which should facilitate more efficient price discovery.