The real active versus passive

Large amounts of money directed into passive strategies may make the market less able to react to minor distortions on the fundamentals side.

The active versus passive debate has moved on to what the rise in passive strategies means for the way markets operate. What happens to equity markets when a large proportion of stocks are held in passive funds?

“This has to make them less efficient ... the issue is quantum,” says Coronation chief information officer Karl Leinberger.

He believes there is a point when the currently-small impacts become significant.

Morgan Stanley’s global head of foreign exchange strategy, Hans Redeker, has raised concerns that large amounts of money going into passive strategies make the market “less able to react to minor distortions or minor declines on the fundamentals side”.

You will not see the market direction, just a continued inflow of funds.

As this is unknown territory, nobody knows at what point it gets serious. ETFGI managing partner Deborah Fuhr, however, believes we are far from it.

“In the US, exchange-traded funds are only 11.4% of mutual fund assets ... Overall in the US, index management is probably 30% of all market assets.

“So while nobody knows the threshold at which you can say there is too much money in index funds, it’s definitely a lot more than what we have today.”

SA passive funds hold 2% of assets under management in collective investment schemes. But etf SA’s independent strategist Nerina Visser warns the proportion of trade needs to be looked at. That dictates whether the market still has efficient price discovery.

Concentrated markets

Leinberger says the impact of passive strategies is likely to be most felt in concentrated markets, like SA. In this instance, passive investors end up with large positions in only a few very big companies that tend to become overvalued.

John Green, Investec Asset Management’s global head of client group, says this is a very important consideration. “Capital being provided to corporates is not being used as effectively as it should be to generate value. As passive levels increase and as capital is deployed in less efficient ways, there are consequences for economic growth and overall market value. “The consequence is ultimately that equity markets are going to be downgraded and growth is going to be less than the best,” Green says. “So, arguably, your equity risk premium for good firms would increase, but overall returns would decrease.”

Opportunity for active

But Visser believes one still has to see the broader context.

“A concentrated market is not only concentrated in terms of the shares listed, but in terms of the large asset managers and their equity exposures, which to a large extent will reflect the market.”

She points out that the Public Investment Corporation, which owns between 10-15% of the JSE, has a SWIX-related mandate so it is obligated to follow the market to alarge degree.

It has to make them less efficient… the issue is quantum