Do ETFs make markets less efficient?

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Chanchal Samadder - Head of Equity ETFs, Lyxor ETF
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Chanchal Samadder - Head of Equity ETFs, Lyxor ETF

Partner Insight: ETFs provide investors with the benefits of cost efficiency, broad diversification and an easier way to control their asset allocation.

However, some active managers also claim that ETFs are making the market less efficient because they buy or sell stocks regardless of valuations. This, the argument goes, gives active managers the opportunity to uncover mispriced stocks.

Yet studies suggest this is somewhat of a fallacy and that new ETFs can in fact help make markets more efficient if they are built in the right way. Indeed according to a 2016 research paper by Professor Semyon Malamud of the Ecole Polytechnique Fédérale de Lausanne and Swiss Finance Institute, adding new ETFs to those already in issue can reduce systemic risk, which means the overall level of risk of the market does not depend on the number of ETFs in existence - or the size of their assets under management.

Head of Equity ETFs at Lyxor, Chanchal Samadder, shares this view and adds that the current potential for these vehicles to impact their underlying assets is negligible. He explains that trading has not been the primary driver of ETF growth; instead, ETFs have been adopted as building blocks for mixed-asset investors.

"The biggest users of ETFs are professional investors building multi asset portfolios. These aren't speculators - they'll be invested for the long term," he says. "Wealth managers and multi asset funds use ETFs as a simple way to invest in a wide range of assets at low cost. Time and again, we hear investors are growing disenfranchised with expensive active alternatives which haven't lived up to the hype."

Understanding ETF thematics

Non-market cap weighted strategies like smart beta, objective-driven, thematic and specialised ETFs look beyond a company's market value, looking instead at the fundamentals or economics. As they grow, they are playing a part in the market's price discovery mechanism - in the same way as a traditional stock picker.

Samadder adds: "Add the accelerating growth of sectors and themes to that of smart beta, and it's clear more and more people are looking for diversification and alternative sources of return to get more from their money in today's low rate environment. Assets here are growing faster than the market overall and we expect this segment will be one of the main growth drivers of the ETF market in the future.

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According to Samadder, introducing new ETFs can have a positive impact on market efficiency depending on their index design. And ultimately, he adds, the growth of the ETF market is likely to be driven by ETFs in non-market capitalisation-weighted indices (sectors, themes and smart beta), which tend to be used by sophisticated investors.

"This should improve, rather than diminish, market efficiency."

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