But if the findings of a group of academics are to be believed that's simply not true.

In fact, the opposite may be occurring. Exchange-traded funds may have actually made markets more efficient and made markets more active than passive.

At the UBS quant conference in Sydney last week Professor Talis Putnins, of the University of Technology Sydney and the Stockholm School of Economic presented the findings of a paper titled The Active World of Passive investing, which he co-authored with David Easley from Cornell University and UTS colleagues David Michayluk and Maureen O'Hara.

His first point was if there are any distortions created by ETFs, fund managers are doing a poor job of exploiting them. The share of US active funds that are beating their benchmark has declined well below its 20-year average of 45 per cent to about 25 per cent while more funds are materially lagging returns on investable index tracking products over three years.

Markets becoming more efficient

And Putnins pointed to two recent academic studies that suggested nothing unusual in the correlations between stocks or how they react to information to suggest widespread distortions.

So what is going on?

In the presentation Putnins put forward several compelling reasons why ETFs are making markets more, not less, efficient.


One is that the rise of exchange-traded funds has opened up a broader and deeper pool of stocks that are made available to short sellers, "thus relaxing short seller constraints".

ETFs, like many funds, can generate additional income by loaning out the stocks they own to short sellers. And in the race to zero fees, their business models may rely on this revenue.

As ETFs that track small cap indices have grown, the net result is that more shares that had been previously difficult to borrow, have been freed up. This, he says means that securities that may have previously been mispriced because they were hard to short, are now less so.

Putnins also points out that it's a misnomer to suggest ETFs are synonymous with passive investing.

While all ETFs are designed to track an index, in the majority of cases, these indices are constructed so that the investor can make an active bet on a sub-set of the market, an industry, a theme or even a factor.

In fact, in the US "active" ETFs dominate the number of funds on offer (with 84 per cent defined as very active) and by dollar volume (with 86 per cent defined as very active). By assets under management, 58 per cent of US ETFs are moderately or very active while 10 per cent are very passive.

ETFs are also actively traded.

Hedging potential


As Vanguard founder and the father of passive investing Jack Bogle pointed out, the 100 largest ETFs have an annualised turnover of 785 per cent compared to 144 per cent for the largest stocks.

Bogle, it should be pointed, is not exactly cheering the rise of ETFs because he believed they would result in passive exposures being actively traded.

Putnins also points out that ETFs have actually been used by highly active fund managers to give them more confidence to bet on single stocks.

The evidence Putnins presents here is the high short interest evident in "industry ETFs".

If there is a high degree of shorting of a particular industry ETF, for instance one that tracks bank stocks, academics have found that it does not predict bad future industry performance. This does, however, increase the likelihood of a positive surprise for a single stock in that sector.

Therefore, if an active manager has a strong view on a particular company but is less sure about the movement of the overall industry, they might buy the shares and short the industry ETF.

Finally Putnins argues that large institutional investors have turned to ETFs to make what are known as "factor bets". Factor ETFs are often referred to as "smart Beta" that track a rules-driven index that buys stocks based on certain characteristics such as value, price momentum or quality. Investors in aggregate, Putnins says, have been surprisingly good at timing these factor bets.

The case that ETFs are not "negatively affecting the informational efficiency" of the stock market is a compelling one.

For instance, money can be made by anticipating rebalancings and flows that arise as a result of ETFs.

But the findings should force a rethink of the view that a tidal wave of "passive investing" has made the market dumber and (eventually) easier to beat.