Much has been written in the past few years about the fast-growing percentage of equity fund assets that is passively invested in index funds and ETFs (chart below). Their market share has grown to over 25% of U.S. equity funds and over 15% of global equity funds in the last 20 years. Many commentators have suggested that, as the percentage of passive equities grows beyond a certain threshold, stock markets will become much less efficient, due to insufficiently active share trading and price discovery.
However, a recent article
by S&P Dow-Jones Indices points out that, even as the percentage of passive equities rises well above 50% of the market, the share of trading by active investors won't be appreciably diminished. The reason is the difference in turnover between active and passive management. In the chart below, it's assumed that passive equities have a 10% annual turnover rate, while active equities have a 100% turnover rate. If 70% of the market is eventually indexed, active managers will still be doing more than 80% of the trading, even assuming no increase in the number of active traders
NOTE: Assumes that passive turnover rate is 10% annually and active turnover is 100%.
Source: S&P Dow-Jones Indices
It's the percentage of active trading, not the percentage of assets passively invested, that sets security prices. If active trading makes for an efficient market, then indexing has a VERY long way to go before market efficiency is affected — even with no new additional active traders entering the market.