#73 What happens if everyone is buying only ETFs?

In 2023, a quiet revolution took place in the U.S. capital market: for the first time, passive investments accounted for more than half of total fund assets. In Europe, too, the trend is pointing sharply upward – even if the market penetration of ETFs and index funds is proceeding somewhat more slowly there.

The reasons for the success of passive ETFs are obvious: Thanks to intense competition, they have become extremely cost-effective and can be traded with liquidity at any time. Passive investments regularly outperform their active counterparts, as this blog post shows.

Concerns about a tipping point

Advocates of active investing argue that if everyone were to invest passively, eventually no one would analyze corporate balance sheets and income statements anymore. As a result, there would be more mispricing, and market efficiency would erode.

However, this notion of a dangerous tipping point is unfounded.

Why pricing remains intact

Although ETFs hold a good half of all fund assets, they are «silent» owners. They simply buy and hold what the market as a whole represents. Although passive funds have grown significantly, over 90 percent of daily trading volume still comes from active market participants such as hedge funds, high-frequency traders, and managed equity funds. Actual price discovery takes place precisely there: in active trading.

Even if 99 percent of the stock market were held by passive investment vehicles, it would make it all the more lucrative for the one percent that continues to trade actively.

The more inefficient a market becomes, the higher the potential alpha – that is, the potential excess return for active market participants. This creates a strong financial incentive for professional investors to bet against mispricing in the market. As long as there are enough traders who react immediately to every inefficiency, the price-discovery mechanism remains fully intact.

For retail investors, ETFs therefore remain the top choice for benefiting from the overall market at low cost, minimizing individual-stock risk, and at the same time not missing out on the few big winners that drive the market upward.

Where active management makes sense

Active management certainly has its place – though primarily in illiquid asset classes. A typical example of this is the allocation of venture capital to innovative startups that require a great deal of capital until they achieve a breakthrough. However, private equity and venture capital should make up only a very small portion of a private portfolio at most.

Has your bank advisor also fed you the story about the alleged ETF bubble? What arguments did he put forward? Feel free to send me an email.