Huge shift to pas­sive sparks fears of chaos

Race to­wards dominance stirs de­bate on whether ETFs curb ef­fi­ciency and ac­count­abil­ity

Financial Times USA - - MARKETS & I NVESTING - ROBIN WIG­GLESWORTH

Wall Street looks set to pass a mile­stone within a year that will cause ul­cers in parts of the in­vest­ment in­dus­try and raise some thorny ques­tions for the US stock mar­ket.

While the per­for­mance of fund man­agers has im­proved this year, the tor­ren­tial in­flows into cheap ex­change traded funds have continued un­abated. San­ford Bern­stein pre­dicts that more than 50 per cent of eq­uity as­sets un­der man­age­ment in the US will be pas­sively man­aged by Jan­uary.

This has stirred the long­stand­ing de­bate over whether the US stock mar­ket’s ef­fi­ciency is erod­ing as more money is al­lo­cated bluntly by ETFs rather than hu­man stock­pick­ers.

“How much pas­sive is too much is a tricky ques­tion to an­swer,” says Mustafa Sa­gun, chief in­vest­ment of­fi­cer for global equities at Prin­ci­pal Global In­vestors, which man­ages $411bn. “But we are see­ing some short-term anom­alies, some move­ments that aren’t caused by fun­da­men­tals.”

The worry is that the as­cent of pas­sive in­vest­ment means mar­kets will be­come more chaotic, un­pre­dictable and brit­tle, while com­pa­nies will not be held to ac­count, sloth will be re­warded in line with dili­gence, and ul­ti­mately this will cor­rode Amer­ica’s eco­nomic dy­namism.

While this may be a self-serv­ing ar­gu­ment by an in­dus­try un­der mount­ing pres­sure, in­vestors say there are a grow­ing num­ber of odd shifts in the US stock mar­ket caused by ETF flows, with many start­ing to in­cor­po­rate these glitches into their in­vest­ment process.

Re­search from aca­demics at Stan­ford Univer­sity and Emory Univer­sity in the United States and the In­ter­dis­ci­plinary Cen­ter of Her­zliya in Is­rael has fu­elled con­cerns that ETFs are de­tract­ing from the stock mar­ket’s ef­fi­ciency.

They found that in­creased ETF own­er­ship sapped shares of their trade­abil­ity and how ef­fi­ciently they re­spond to shift­ing fun­da­men­tals such as earn­ings, even as the cor­re­la­tion to the broader stock mar­ket and over­all re­turns in­creased.

A 1 per­cent­age point in­crease in ETF own­er­ship in­creases cor­re­la­tion to the com­pany’s in­dus­try and broader mar­ket by 9 per cent, bid- ask spreads in­crease by 1.6 per cent while the re­la­tion­ship be­tween its price and fu­ture earn­ings slips 14 per cent, they found

“ETFs are clearly an im­por­tant de­vel- op­ment in fi­nan­cial mar­kets that have brought many well-doc­u­mented ben­e­fits to in­vestors,” Doron Is­raeli, Charles Lee and Suhas Srid­ha­ran wrote in an up­dated pa­per pub­lished this month.

How­ever, “our ev­i­dence sug­gests the growth of ETFs may have (un­in­tended) long-run con­se­quences for the pric­ing ef­fi­ciency of the un­der­ly­ing se­cu­ri­ties.”

Some an­a­lysts and fund man­agers are de­tect­ing wor­ry­ing signs that the pas­sive tide is also af­fect­ing ac­count­abil­ity.

Mike Maio, an in­de­pen­dent bank an­a­lyst, says he has seen how pas­sive in­vestors are laxer on ques­tions of cor­po­rate gov­er­nance. “I am con­cerned that man­age­ment will be less ac­count­able with the rise of pas­sive in­vest­ing,” he says.

Even the god­fa­ther of pas­sive in­vest­ing — Van­guard founder Jack Bogle — re­cently ad­mit­ted that “if ev­ery­body in­dexed, the only word you could use is chaos, catas­tro­phe”.

But he said this was an un­re­al­is­tic prospect, given that at some point the mar­ket’s ef­fi­ciency erodes enough for it to be a bet­ter en­vi­ron­ment for tra­di­tional stock­pick­ers, im­prov­ing their for­tunes.

That is some­thing that the in­vest­ment in­dus­try has been pre­dict­ing for a long time with lit­tle ev­i­dence thus far that it is about to come true.

In­deed, the av­er­age per­for­mance of US fund man­agers has largely at­ro­phied in tan­dem with the rise of pas­sive in­vest­ing.

“Whether there’s a point where ac­tive can ex­ploit op­por­tu­ni­ties thrown up by more pas­sive in­vest­ing is the tril­lion dol­lar ques­tion,” says Lynn Blake, chief in­vest­ment of­fi­cer for State Street’s pas­sive eq­uity divi­sion, which con­trols the world’s big­gest ETF. “We’re not at that point yet. We have a long way to go be­fore we’re wor­ried.”

Some fund man­agers agree. Ge­orge Evans, chief in­vest­ment of­fi­cer for equities at Op­pen­heimerFunds, ar­gues that even when more than half the mar­ket is pas­sive it will not im­pede the “price dis­cov­ery” role that ac­tive in­vestors play.

He takes a Dar­winian view of its role in the in­dus­try ecosys­tem. “I see the rai­son d’être of pas­sive in­vest­ment as driv­ing out the poorer play­ers,” he says.

In­deed, even when the 50 per cent mile­stone in as­sets un­der man­age­ment is passed, pas­sive funds would only ac­count for about 14.5 per cent of the over­all US eq­uity mar­ket, Inigo FraserJenk­ins, head of quan­ti­ta­tive eq­uity strat­egy at San­ford Bern­stein points out. The bal­ance is held by in­vestors di­rectly or by com­pa­nies them­selves.

More­over, the rise of com­puter-pow­ered “quan­ti­ta­tive” in­vest­ment strate­gies that sys­tem­at­i­cally scour mar­kets for lu­cra­tive in­ef­fi­cien­cies prob­a­bly means that the pas­sive tide could rise much higher be­fore the ef­fi­ciency of the stock mar­ket gets swamped.

Mr Fraser-Jenk­ins once raised eye­brows by claim­ing that pas­sive in­vest­ing was worse than Marx­ism, but says there may not be any spe­cific tip­ping points where ac­tive in­vest­ing be­comes eas­ier, or the stock mar­ket’s role in al­lo­cat­ing cap­i­tal in the economy be­gins to break down.

Nonethe­less, he stresses that the in­creas­ingly pas­sive land­scape is “the new real­ity for the in­vest­ment world from now on. Peo­ple need to get used to it”.

Spencer Platt/Getty Images

Re­search sug­gests that the growth of ETFs may have un­in­tended long-run con­se­quences for the pric­ing ef­fi­ciency of the un­der­ly­ing se­cu­ri­ties

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