Passive investing: staying the right side of insanity
Tom Traill - 04 October 2018
The meteoric ascent of passive investment – mainly using mutual funds and exchange-traded funds – confers peculiar status on equity index constituents, leading to increasing market concentration especially where stocks have multiple index memberships. Favoured companies have the opportunity to make acquisitions at low cost, boosting market capitalization and index weight in the process. In the extreme, this dynamic funnels investors into mega-stocks that are destined to disappoint the weight of expectation placed upon them. The paradox of passive investing is that it requires the participation of a critical mass of active value investors to insure against insane outcomes.
A clear winner from the QE era is the low-fee index tracking funds, which have performed well, with strong capital growth and relatively low volatility. However, the logic of ETFs that mimic market-cap weighted indexes requires that new money is increasingly allocated to large stocks with positive price momentum. This creates a piling-on effect as funds buy more of these increasingly expensive stocks and less of the cheaper ones in their indices — the polar opposite of the “buy low, sell high” mantra. Bubble risks arise when there is no regard for underlying fundamentals or price. These dynamics can unravel equally quickly to the downside: stocks that were disproportionately bought because of ETFs and index funds will be disproportionately sold.
But again, in a crisis will the ETF managers find liquid markets? When an ETF stock price falls below the value of its underlying assets, authorised participants (usually banks) step in to buy discounted ETF shares and sell them at a premium. Banks are happy to perform this market-making role when markets are calm, but will they — can they — in the face of sustained market turmoil?
At first glance one might assume that investing in a tracker fund – buying a market cap weighted portion of each company – should just increase all the of the constituent parts equally. But while the index seeks to approximation of all stocks there are plenty that do not fulfil all the criteria needed for inclusion: some may not have sufficient free floating shares, or insufficient profitability. Few investors will know even the basic contents, let alone the intricacies of their funds. Money is being channeled into shares of companies that the investors have never heard of and have no preference to hold ahead of alternative firms outside of the index.
The BIS has done work, illustrated in figure 1 below, which shows that inclusion in the S&P 500 increases correlation and improves liquidity. The price of index exclusion is high. Now bear in mind that some firms, such as Apple will be included in several indexes: the NASDAQ, NASDAQ 100, S&P 100, S&P 500, DJIA as well as various smart-beta funds and FAANG and tech ETFs etc. The more index representations, the greater the compounding flows from passive investors.
For as long as information moves markets, as well as liquidity, passive investors must hope that a sizeable rump of active value investors remains, to moderate the de-stablising dynamics that would otherwise prevail.
Figure 1: Inclusion in the S&P 500 increases correlation and improves liquidity
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