Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 589

Where is peak ETF?

The market share of ETFs and index trackers keeps rising and with it concerns about reduced market efficiency. In theory, if everyone would simply track an index, new information would no longer be reflected in share prices, and it would become highly profitable to be active and short stocks with negative news flow while buying stocks with positive news flow. This theoretical argument shows that there should be an equilibrium between index funds and active investors or that markets stop working. But where that equilibrium is, is anyone’s guess.

If we look at the latest figures from the Investment Company Institute about ETF market share in different countries (note this is across stocks, bonds, real estate, and commodities, so the numbers are lower than equity markets alone) we can see that in Anglo-Saxon countries, ETFs and index trackers typically have a much higher share than in continental Europe. Japan and South Korea seem to follow more the US and UK example, which is why we should consider Germany, France, or Switzerland outliers (there is a future post in that statistic somewhere).

Market share of ETFs across all major asset classes

Source: ICI, The Investment Association

The question is whether the market share of 15-25% reached by index trackers today is the peak. I doubt it and I expect index trackers to continue to gain share for many years to come.

But there are also increasing signs that with the rising share of index trackers, markets are becoming less efficient, particularly in the large-cap space.

Theresa Hambacher reviewed the last 20 years of research on index funds to see if index funds really reduce market efficiency and if active managers can drive markets back toward efficiency if too many investors switch to index trackers.

Her literature review concludes that the majority of studies show that the rise of index investing creates an ‘index inclusion effect’. Historically, this index inclusion effect meant a price jump in stocks that are newly included in an index and a drop for stocks that are excluded. But this price impact has declined significantly and all but disappeared in the US.

Nowadays, the index inclusion effect is more related to other metrics, most notably an increase in liquidity in stocks in an index. With this increase in liquidity also comes an increase in investor attention and a somewhat higher valuation. The increase in investor attention leads to higher institutional ownership, higher analyst coverage, and increased media coverage. But it also has other, more material effects. Most notably, increased liquidity and higher valuations reduce the cost of capital for both debt and equity capital and thus give index constituents an advantage over smaller stocks that are not part of the index.

On the other hand, there is ample evidence that market efficiency and price discovery decline if index funds capture a larger share of the market. This should in principle give an opening for active managers, who on average increase price efficiency and take advantage of market mispricing.

The reality, however, is more complex. Market efficiency is driven by a whole lot of factors, not just the share of index funds. This means that if active funds capture market inefficiencies and make markets more efficient, this does not drive investors away from index funds. Instead, markets may adjust in such a way as to become more efficient without reducing the market share of index funds. Plus, market efficiency is not the only driver of index fund market share. Hence, active funds may outperform index funds and improve market efficiency but get no reward in the form of higher market share. Instead, index fund investors may simply free-ride on the work of active fund managers.

These two effects are not new. They have been known for some time. But taken together they imply that the market share for index trackers may well increase past the optimal level and stay there for many, many years. And there seems very little if anything that active managers can do to reverse that. Hence, we do not know where peak ETF is, and while active managers provide a valuable service in making markets more efficient, they are not necessarily rewarded for it by capturing a larger share of investor assets.

 

Joachim Klement is an investment strategist based in London. This article contains the opinion of the author. As such, it should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of the author’s employer. Republished with permission from Klement on Investing.

 

RELATED ARTICLES

Are markets broken?

The challenges of building a lazy portfolio

The challenges with building a dividend portfolio

banner

Most viewed in recent weeks

Raising the GST to 15%

Treasurer Jim Chalmers aims to tackle tax reform but faces challenges. Previous reviews struggled due to political sensitivities, highlighting the need for comprehensive and politically feasible change.

Here's what should replace the $3 million super tax

With Div. 296 looming, is there a smarter way to tax superannuation? This proposes a fairer, income-linked alternative that respects compounding, ensures predictability, and avoids taxing unrealised capital gains. 

100 Aussies: seven charts on who earns, pays, and owns

The Labor government is talking up tax reform to lift Australia’s ailing economic growth. Before any changes are made, it’s important to know who pays tax, who owns assets, and how much people have in their super for retirement.

9 winning investment strategies

There are many ways to invest in stocks, but some strategies are more effective than others. Here are nine tried and tested investment approaches - choosing one of these can improve your chances of reaching your financial goals.

The rubbery numbers behind super tax concessions

In selling the super tax, Labor has repeated Treasury claims of there being $50 billion in super tax concessions annually, mostly flowing to high-income earners. This figure is vastly overstated.

With markets near record highs, here's what you should do with your portfolio

Markets have weathered geopolitical turmoil, hitting near record highs. Investors face tough decisions on valuations, asset concentration, and strategic portfolio rebalancing for risk control and future returns.

Latest Updates

Investment strategies

Finding income in an income-starved world

With term deposit rates falling, bonds holding up but with risks attached, and stocks yielding comparatively paltry sums, finding decent income is becoming harder. Here’s a guide to the best places to hunt for yield.

Economy

Fearful politicians put finances at risk

A tearful Treasury chief, a backbench rebellion, and crashing bonds. What just happened in the UK and why could Australia’s NDIS be headed for the same brutal fiscal reality?

Shares

Investing at market peaks: The surprising truth

Many investors are hesitant to buy into a market that feels like it’s already climbed too far, too fast. But what does nearly a century of market history suggest about investing at peaks?

Shares

Chinese steel - building a Sydney Harbour Bridge every 10 minutes

China's steel production, equivalent to building one Sydney Harbour Bridge every 10 minutes, has driven Australia's economic growth. With China's slowdown, what does this mean for Australia's economy and investments?

Investment strategies

Will stablecoins change the way we pay for things?

Stablecoins have been hyped as a gamechanger for the payments industry. But while they could find success in certain niches, a broader upheaval of Visa and Mastercard's payments dominance looks unlikely.

Infrastructure

An investing theme you can bet on for the next 30 years

Investors view infrastructure as a defensive asset class rather than one with compelling growth prospects. These five tailwinds for demand over the coming decades suggest that such a stance could be mistaken.

Investment strategies

A letter to my younger self: investing through today's chaos

We are trading through one of history's most confounding market environments. One day, financial headlines warn of doomsday scenarios. The next, they celebrate a new golden age. How can investors keep a clear head?

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.