#52: Can ETFs break the market?

Since Simon and I are both vocal fans of index trackers, we are often asked about the possibility that ETFs could break the market. The questions submitted by Jaco de Wet this week are questions we field often. The fear is that index trackers will become such a large part of the market that price discovery will be compromised and management won't be held accountable due to a lack of shareholder engagement.

If you're not completely new to the investment world, odds are you've heard the phrase, "Past performance is not an indication of future performance". If you speak to someone who has been investing for a while, you've probably also heard them say that some market event is unlike anything they had ever seen.

While the market tends to trend higher over time, "unlikely" market events happen all the time. Think 2008, tech bubble and even the introduction of index trackers. Who saw it coming? Nobody. Why? Because the market is organic.

In its purest form, the stock market is made up of those with money to spare (investors), those raising money (companies) and the people and institutions that facilitate these transactions. While the players in the market remain constant, the conditions surrounding the lending and borrowing that occurs in the market change with the times.

If the market hadn't adapted to the times, the JSE, which was founded in 1887 after the discovery of gold in the Witwatersrand, would be a market for gold. The introduction of ordinary listed companies didn't break the market. The market adapted to the needs of its constituents.

The argument Simon and I try to formulate this week centers around the fact that the market isn't static. Both markets and legislation change to reflect the needs of the times. If index trackers in their current form became so prevalent that they become major shareholders of companies, price discovery and accountability certainly will become an issue.

However, in the time it will take to get to that point in the market, the market will adapt. Legislation will adapt. Index trackers themselves will adapt. For as long as there is a market, there will be people in the market seeking profit from inefficiencies. While ETFs and other index trackers can certainly change the market the way listed companies changed the market, the market will adapt.  

Kris