Exploring the pros and cons of index funds and ETFs

Despite the huge individual benefits offered by cheap diversification via index funds and Exchange-Traded Funds (ETFs), we also need to keep in mind their associated side effects, said Martin Schmalz, Professor of Finance and Economics in the Saïd Business School at the University of Oxford, during his recent Henry Thornton Lecture.

Inaugurated in 1979 and hosted by the Centre for Banking Research at Bayes Business School (formerly Cass), the Henry Thornton Lecture Series focuses on monetary theory, monetary policy and finance. Titled ’Do index funds benefit society?’, Professor Schmalz’s talk took place in the School on Wednesday 24 May 2023, and discussed at length recent research on the question as well as future areas of interest.

Investing for everyone 

While the idea behind index funds was first proposed in the late 1960s, with ETFs coming later in the 1990s, they have increased massively in popularity ever since, with an estimated $10 trillion in total assets under management in ETFs globally. Both enable investors to own a fund that tracks a specific basket of underlying investments, with thousands of different options for consumers. The three big asset managers, namely Vanguard, BlackRock and Fidelity, currently control around 23 per cent of the average S&P 500, which tracks 500 of the largest public US companies by market cap.

But even though index funds are, according to Professor Schmalz, one of the most influential and successful innovations of the 20th century, we also need to be aware of the drawbacks. Following an introduction by Professor Vasso Ioannidou, Associate Dean for Research at Bayes, Professor Schmalz set about answering the question posed by the lecture, in particular focusing on three categories of potential concern that come with cheap diversification, and index funds and ETFs as presently practised.

It’s probably not an exaggeration to say that index funds are perhaps one of the most influential and successful innovations of the 20th century

Current concerns 

The first, Professor Schmalz said, relates to side effects, as the argument goes that if the index fund providers become so large as to become the most influential shareholders of many of the portfolio firms, then arguably that changes the way these firms are governed. This is because it weakens governance and distorts competition between these portfolio firms, which include many competitors.

The second category focused on equilibrium effects, namely the idea that when many of us put our pension and retirement money into index funds and ETFs, it appears to increase equity prices. Having discussed a recent theoretical model, Professor Schmalz went on to say that when equity prices are higher, but the profits stay the same, that means returns are lower. “Ironically, index funds which are good for individuals are actually bad for investors as a group,” he added.

Professor Schmalz’s third point concerned the tax-efficient nature of ETFs, and whether this is socially beneficial given that they tend to be held by affluent households or individuals. As opposed to index funds, ETFs are more liquid and can be traded throughout the day. By also reinvesting dividends, and not realising the payout, people in some jurisdictions can also avoid paying income tax. In addition, by carrying out a ’wash sale‘ by swapping ETFs that ostensibly track the same investments, such as the S&P 500 in the US, individuals can realise a loss and then get a tax deduction when the investment hasn’t fundamentally changed.

“The reason ETFs exist is because hedge funds want to shorten entire sectors, but an additional reason might well be that it makes tax harvesting more efficient. It’s unclear to me that this is necessarily socially beneficial as it’s helping rich people avoid taxes on a large scale,” he said.

Final thoughts 

Revisiting the topic of the lecture, Professor Schmalz concluded his talk by saying that while there are evidently huge individual benefits, there are also notable side effects in terms of distortions of governance and competition.

“Clearly, there are equilibrium effects and people have not thought much about that. But especially when you think about regulation, it seems necessary to think about these aspects as well as the tax effects. And so, as we think about the social usefulness of this amazing invention – and it’s the most successful invention of the past few decades – I think we should keep these three categories and perhaps more,” he added.