Huge shift to passive sparks fears of chaos
Race towards dominance stirs debate on whether ETFs curb efficiency and accountability
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”.
Research suggests that the growth of ETFs may have unintended long-run consequences for the pricing efficiency of the underlying securities