Indexing still has a lot of runway

Total assets in Canada-domiciled ETFs alone increased more than 50% during the last five years, in excess of $70 billion at the end of September. So, some investors are beginning to wonder: Is indexing getting too big?

The answer is no.

First, let’s understand how big indexing is today.

In Canada, the vast majority of indexed assets (about 80%) are in ETFs. But while ETF growth has been impressive, actively managed mutual funds continue to dominate, accounting for close to 90% of the total fund assets.

Growth of Canadian ETFs

Indexing remains more popular in the U.S., where it amounts to 25% of total assets. But, even there, it hasn’t attained a size that would give rise to concern, and likely never will. Even if a majority of investors indexed, the zero-sum game dynamic—where for every investor’s dollar that outperforms the market, another investor’s dollar must underperform—would still be intact, and active investors would still determine market prices.

As of year-end 2013, index funds and ETFs constituted 35% of equity funds and 17% of fixed-income funds. And while that seems significant, we know that mutual funds are only one component of the investment markets.

In terms of total dollar market value, index funds constituted 14% of equity market value and 3% of fixed income market value, meaning that more than 85% of the equity market and more than 95% of the bond market were invested in some form of active management (e.g., individual securities, hedge funds, or managed accounts).

Zero-sum game

Another thing to keep in mind: Investing is a zero-sum game.

Prices are set and continuously reset by active investors seeking to profit from their knowledge and beliefs. Indexers, on the other hand, attempt to passively track the market at the prices set by those active investors. Even if active investors only made up a small portion of the market (and only a few large active investors are theoretically, all that’s required), as long as some profit motive existed, they would still be competing with each other for an opportunity to make a gain.

Consequently, active investors would continue to buy and sell for profit, helping to sustain a market in which stock prices reflect all available information.

But what if every investor decided to index? Theoretically, there would be no way to establish a continuous market price for securities in an all-indexed market, creating biased estimates of the true value of investments. But that environment would then create opportunities, at which point active traders would jump back into the market to take advantage of them.

In practice, it’s inconceivable that a market would ever get to that point. The profit motive drives investors to take risks, and it is a powerful catalyst for market efficiency.

Chart: Canada ETF Assets and Number or ETFs by Year

By Atul Tiwari, managing director, Vanguard Investments Canada.