Weapons of mass destruction.
“But what have WMDs got to do with passive investing?” you might ask. Well that’s exactly how exchange-traded funds (ETFs) – the most common type of passive investment instrument – were described by some fund managers earlier this year.
According to Arik Ahitov and Dennis Bryan who run the $800 million fund FPA Capital, “ETFs are weapons of mass destruction” that have distorted stock prices. And the mounting evidence suggests that they have a point. The growth in passive investment is increasingly perceived – and derided – as being excessive, especially by active fund managers who see it causing a breakdown in the ability of financial markets to price assets and efficiently allocate capital. But why is this the case?
Active vs. Passive Investments
Those who support active management, such as Mr. Ahitov and Mr. Bryan, endorse the process of assessing the underlying fundamentals of each individual security in order to ascertain how it is likely to perform in the future. Investing $100 in a growth-focused mutual fund, for instance, would induce the active fund manager to invest in those companies that she thinks will deliver the best returns. And this is conducted by reviewing a diverse set of fundamental parameters underlying each individual stock before proceeding with an investment decision, such as the company’s Price/Earnings and Price/Book Value ratios; as well as assessing how future interest rate expectations should be integrated into the overall calculus of earnings growth, and studying the company management’s performance history.
In contrast, proponents of passive investment largely ignore such fundamental information. Instead, a fund’s portfolio is usually comprised of securities that provide a proportional representation of an index. As such, the performance of the fund will mirror that of the broader benchmark. For example, investing $100 in an ETF that tracks the S&P 500 means that money is allocated in accordance with the weighted composition of the index – if Apple constitutes 2.5%, then $2.50 will be invested in Apple.
There is no question that passive investing, particularly via ETFs and indexed mutual funds, has exploded in recent years; what’s more, this surge has concurrently been at the expense of waning interest in actively managed funds.
Between 2014 and Q1 2017, for instance, the Investment Company Institute recorded a net withdrawal of $773 million of assets in actively traded mutual funds in the US, whilst during the same period, investors increased their participation in index funds and ETFs by $596 million. And according to some estimates, the amount pulled in by passive products during 2017 could end up being double what they were only 2 years ago, underlining just how astronomical their rise has been.
The growing popularity of such index-linked products is mostly down to their simplicity, low cost and convenience, which suggests they attract a higher concentration of less sophisticated investors. Prior to the rise of index funds, experienced traders and fund managers who were well-versed in fundamental analysis could more easily generate profits by executing individual stock transactions with such investors – this was a big part of the competitive advantage that they once held – that uninformed cohort can now simply opt to put their money into ETFs. Although in doing so, they are creating distortions in the market, with company stock prices becoming less representative of their own fundamental performance.
The Zombification of Markets
One of the main problems with investing in stock indices over individual stocks is that it results in no discernible “price discovery” for those stocks. Passive funds ignore information pertaining to individual stocks. Given that they must buy stocks in proportion to the index they track, scant regard is shown for fundamentals, and a herd mentality is adopted at the expense of individual stock-picking. So, when markets experience a greater proportion of passive investment, individual stocks move more in concert with their benchmarks. In the words of Messrs Ahitov and Bryan, “The flood of money into passive products is making stock prices move in lockstep and creating markets increasingly divorced from underlying fundamentals”. Thus, such stocks gradually abandon their unique, idiosyncratic price movements that are reflective of their true valuation, and are instead become more correlated with the rest of their index constituents, as well as the index itself.
This “zombification” of stocks means that fewer signals about corporate performance are reflected in the stock price over time. In turn, this makes life tougher for traders and active fund managers who rely on such signals to identify informational edges and exploit mispriced securities as a way of turning in a profit.
Declining liquidity is another notable – albeit unintended – bi-product of more passive investment. Active fund managers track the movements of individual companies more closely than their passive peers, which means they are more likely to be buying and selling each stock more frequently, as dictated by changes in the underlying fundamentals. As such, a decline in active management – and a rise in passive investment – will be accompanied by a fall in trading volume associated with each stock. With less overall trading being executed under passive strategies, market liquidity will increasingly suffer, which in turn will widen the bid-ask spreads for individual securities. With passive investment largely mimicking the composition of benchmarks, moreover, smaller companies will suffer the most from declining liquidity, as more money in a passive investment will be apportioned for the bigger companies with higher market values.
Worse still is the fate suffered by those companies that are not included in benchmarks at all, and will thus be automatically ignored by the passive crowd. Such stocks may quickly fall out of favour in terms of analyst coverage (although they may eventually prove fruitful as “turnaround” stocks for sufficiently competent value investors). Nevertheless, with greater proliferation of index-linked funds, market efficiency derived from accurate assessment of fundamentals will decline. And as markets become overly dependent on changes to the composition of benchmark indices, those companies that are included an index will end up being overbought, while excessive selling awaits those stocks that leave an index. Grave misallocations of capital would then become commonplace, which would lead to asset bubbles forming for some stocks and a starvation of funds for others.
What Does The Evidence Say?
Are passive strategies actually lowering market efficiency in the real world? There is now considerable evidence to suggest so. For instance, joint research from Stanford University, Emory University, and Israel’s Interdisciplinary Center Herzliya, found that greater ETF participation is accompanied by a dramatic impact on an individual stock. Over the ensuing year, a 1% increase in ownership of ETFs leads to a 9% rise in correlation between a stock and its industry group, as well as the broader market, which thus implies a greater degree of stock return “synchronicity”.
The relationship between the stock’s price and future earnings, meanwhile, falls by a hefty 14%, thus reflecting the increasing disconnect between price and valuation. A 1% increase in ETF ownership also causes bid-ask spreads to widen by 1.6%, indicating a sizable drop in market liquidity and a rise in trading costs.
According to the authors, the overall results support the view that “increased ETF ownership can lead to higher trading costs and lower benefits from information acquisition. This combination results in less informative security prices for the underlying firms”.
A noted 2014 paper from Virginia Tech, “Indexing and Stock Price Efficiency”, also found similar results. Based on a sample of 591 large and liquid US stocks, the authors found that greater indexing of stocks leads to less efficient prices, “as indicated by stronger post-earnings-announcement drift and greater deviations of stock prices from the random walk”.
And more recently, research from Horizon Kinetics found a substantial increase between the S&P 500 and its largest constituents over the past 20 years. Between 1975 and 2015, for example, the correlation of shares in ExxonMobil with the index has surged from 0.35 to 0.73. The US hedge fund suggests that this increase reflects the greater amount of money being investing in index trackers, which in turn is causing its constituents to move in lockstep with each other – this prevents investors from seeking to profit from buying good companies and selling bad ones.
Are Active Managers Partly Responsible?
The results over the last few years would certainly endorse such a view. In fact, it seems that passive investment’s ascent would not be as steep had active fund managers not performed so abysmally as a collective in recent times. Let’s take the US in 2016 as an example; according to the S&P Indices Versus Active (SPIVA) funds scorecard, over 60% of actively managed stock funds were outperformed by their respective market benchmarks. And when we examine the smaller companies – the mid-cap and small-cap funds – their performance is even worse, underperforming 89.3% and 85.5% of the time respectively. The picture gets even worse when we extend the period under analysis; between 2002 and 2016, the S&P 500 has beaten 92% of large-cap funds, 95.4% of mid-cap funds and 93.2% of small-cap funds. In total, 82.2% of all active funds were outperformed by their respective benchmarks during this period.
Such numbers should provide sober reading for active fund managers – and goes a long way towards explaining why investors are now opting for index-linked funds with greater frequency. Of course, this diffusion from the active world to the passive world has been distinctly expedited in the wake of the financial crisis, which has played a crucial role in introducing a more risk-averse culture throughout financial markets. With central banks also attempting to boost liquidity by pumping trillions of dollars into the financial system through quantitative easing programmes, along with implementing historically low, even negative interest rates, the consequentially distorting effect on asset valuations has not exactly helped the fund manager’s cause in recent times.
But let’s be clear, there remains a wholly convincing case in support of active fund managers. As long as stock prices continue to matter, then so too will active investment. And they still do – they influence a company’s cost of capital which in turn affects its competitiveness; they provide a vital economic signal for mergers, acquisitions and secondary capital raising; and while they may be experiencing a deterioration in their relationship with company fundamentals, they are still responsive to changes in those fundamentals over time. At the same time, with passive investment’s growing influence, it would seem a recommended course of action for active managers to continue seeking new metrics and methods to evaluate corporate performance.
And yet there are still specific periods when active fund managers consistently outperform the market. From 2000 to 2008, for instance, nearly two-thirds of active large-cap funds beat the S&P by an annual average of 1.4%. This suggests that while active managers may fail to outperform benchmarks during bull markets, they tend to perform better when markets are moving sideways or are experiencing corrections, as the 2000-2008 period largely experienced. And when a market crash does transpire in the future, it is likely to be more pronounced in a landscape populated with more passive funds, as money flows away from such funds and towards active strategies. It seems likely that only then we will see the true value of the active fund manager – as well as perhaps the true folly of passive investment.
Fixed income as an asset class also tends to favor active managers, particularly the more illiquid and less transparent products such as junk bonds. With an absence of central exchanges for trading fixed-income securities, and the relative infrequency with which many such securities are traded, there is no central pricing mechanism, which makes profiting from pricing anomalies significantly easier. Moreover, ETFs are unable to adjust the composition of their portfolios to reflect concerns they may have about rising interest rates in the future. As such, certain bonds in a passive bond fund would be adversely impacted, especially treasuries and mortgage-backed securities, whereas a competent active manager would be able to navigate away from the damage that would likely materialize when bond prices start to fall.
Ultimately, there appears to be little on the horizon to prevent passive investing from making further inroads into the overall investment mix. Instruments such as ETFs are clearly an important development in financial markets, and have brought convenience and affordability to investors – both of which seem to be of paramount importance in our post-2008 world. But their growth is having unintended consequences for the pricing efficiency of financial markets.
So we now have a conundrum – passive investment works because it relies on taking decisions predicated on those taken previously by informed market participants. But its growth is crowding out those same informed participants who determined the market prices in the first place. Perhaps it’s wise to heed the words of our resident doomsayers Ahitov and Bryan, one last time, “When the world decides that there is no need for fundamental research and investors can just blindly purchase index funds and ETFs without any regard to valuation, we say the time to be fearful is now.”