How much of the stock market is held by passive investors?
We all know that index funds and ETFs hold an ever-increasing share of the stock market. In the United States, the ICI estimates that some 16% of the stock market is held by index trackers, while in the UK, the Investment Association estimates that the share of index trackers has already crossed the 20% mark.
The problem with these statistics is that they only count the holdings of index funds and ETFs. But we know that pension funds and other institutional investors have established passive portfolios themselves that they manage in-house or as separated accounts at an outside asset management firm. How big is the market share of these index tracking portfolios?
Alex Chinco and Marco Sammon tried to identify the US stock market's true share of index trackers. To do this, they hypothesised that index trackers need to change their holdings when a stock drops out of an index or is newly introduced to an index. So, they looked at the trading volume of these stocks on the day of the index change.
The problem with this approach is that there are a lot of other reasons why these stocks may trade on the day of their index exclusion or inclusion and Chinco and Sammon tried to account for these as best they could. For example, they only look at end-of-day trading volume since index funds tend to submit their orders for execution towards the end of a trading day, not during the day. But the same is true for derivatives traders who have to settle options on a single stock or the index. Thus, they excluded triple-withing days from their analysis to minimise the impact of these option settlements. Using these and other corrections, they estimate that the true share of passive investments is more than double the share of index-tracking funds and ETFs (37.8% at the end of 2020 compared to a share of 15% for passive funds). The gap between the share of passive funds and all passive holdings increased over the last couple of years as the trend towards direct indexing took off.
Estimated total share of passive investments in the US stock market
Source: Chinco and Sammon (2022)
Yet, while the results of Chinco and Sammon make intuitive sense, I cannot help but think that they overestimate the true passive share.
My main concern is that many active funds also trade towards the end of a trading day, simply because every fund manager knows that this is the time of day when market liquidity is highest. On top of that active funds may need to sell a stock that is excluded from an index simply because they are not allowed to hold ‘out-of-universe stocks’ in their portfolio. Or they might invest in a newly admitted stock on the day of its index inclusion because their mandate now allows them to hold what could be an attractive stock. And because the stocks excluded from an index and newly included in an index are at the lower end of the market cap spectrum, they also tend to be among the least liquid stocks in the index. Thus, it makes sense to execute such trades at the end of a trading day when liquidity is highest, even if you are an active investor. And as far as I can see, there is no way the data used in the study above is able to distinguish between these active and passive investors.
But one conclusion is still valid. While I think the true passive share in the US market is not 37% it seems clear that it is likely much higher than the 15% of index funds and ETFs.