Is the growth of passive investing increasing volatility?

By LARRY SWEDROE

The continued rapid growth in market share of passive investing has been accompanied by continuing attacks on it by Wall Street and the financial media. One article called passive investing worse than Marxism. Another said it was causing a bubble. A third said it was causing market turbulence. One even warned that the trillion-dollar shift to passive investments, computerised trading strategies, and electronic trading desks will exacerbate sudden, severe stock drops leading to “flash crashes and social unrest not seen in 50 years.”

To address such concerns Inna Zorina, Jamie Khatri, Carol Zhu, and James J. Rowley, from the research team at Vanguard, examined the question of whether the growth in indexing assets exhibits any causal relationship with market volatility. Their study With Greater Uncertainty Comes Greater Volatility, published in the winter 2019 issue of The Journal of Indexing, began by noting that “some academics and market participants argue that the growth of indexing causes market volatility.” To determine whether this was the case they tested two measures of market volatility for their potential relationship with growth in indexing assets and selected macroeconomic factors.

Standard deviation, defined as month-end trailing, 21-trading day annualized standard deviation of Russell 3000 Index returns.

The CBOE Volatility Index (VIX), which estimates expected market volatility by aggregating the weighted prices of Standard & Poor’s 500 Index puts and calls over a wide range of strike prices.

As a measure of uncertainty, which creates volatility, they used the US Economic Policy Uncertainty Index. As a measure of current economic activity, they used U.S. non-farm payrolls.

The following is a summary of their findings:

The two measures of market volatility — standard deviation and VIX — have historically moved in tandem.

Macroeconomic factors have a strong correlation with and are useful predictors of market volatility. Both business cycles and economic policy uncertainty have substantially positive (and similar in absolute value) correlations with both measures of market volatility. Over the long term, market volatility exhibits an even stronger positive relationship with business cycles.

Volatility seems to be linked to both economic policy uncertainty and the business cycle.

Volatility tends to cluster — extended periods of high market volatility followed by extended periods of low market volatility.

Growth in indexing assets does not exhibit any causal relationship with market volatility. In fact, the correlation between market volatility and growth of indexing is negative and relatively small in absolute terms.

They concluded: “Macroeconomic factors such as economic policy uncertainty — not the growth of indexing assets — are responsible for elevated market volatility.” Their findings are supported by those from a September 2019 study by Federal Reserve researchers.

Further evidence

Kenechukwu Anadu, Mathias Kruttli, Patrick McCabe and Chaehee Shin, authors of the study The Shift From Active to Passive Investing: Potential Risks to Financial Stability? addressed the issue of whether the trend toward passive investing has increased market risks. They examined how this shift affects financial stability through its impacts on funds’ liquidity and redemption risks, asset-market volatility, asset-management industry concentration, and co-movement of asset returns and liquidity. They found that the shift is, in fact, affecting the composition of financial stability risks. However, the impact is not unidirectional. While the effect is increasing some risks, it has reduced others. For example, they found:

The growth of exchange-traded funds (ETFs), largely passive vehicles that do not redeem in cash, has likely reduced risks arising from liquidity transformation in investment vehicles.

Investor flows for passive mutual funds are less reactive to fund performance than the flows of active funds. The result is that passive funds face a lower risk of destabilising redemptions in episodes of financial stress. For example, in charting the cumulative flows for equity funds from December 2007 through mid-2009, and the cumulative flows for bond funds during the “Taper Tantrum” in mid-2013, passive funds had cumulative inflows and active funds had cumulative outflows in both cases.

Passive mutual funds are less likely than active funds to hold highly illiquid assets – holdings of highly illiquid assets can create severe liquidity risks for funds that offer daily redemptions.

Leveraged and inverse ETFs, which seek daily returns that are respectively positive and negative multiples of an underlying index return, must both trade in the same direction as the market moved earlier in the day. Thus, they must buy assets (or exposures via swaps or futures) on days when asset prices rise and sell when the market is down, amplifying market volatility.

Since passive funds use indexed-investing strategies, these funds’ growth could contribute to “index-inclusion” effects on assets that are members of indexes, such as greater co-movement of returns and liquidity. They added that the research found that the effects of index inclusion had declined significantly since 2000. In addition, equity co-movement has declined significantly since 2000.

Stocks with more ownership by ETFs display higher volatility than otherwise similar securities. The volatility arising from ETF trading induces a non-diversifiable source of risk, at least in the short term. However, while ETF trading may lead to pricing distortions for individual ETF-held securities, such trading helps move aggregate market prices closer to fundamentals.

Research has found that passive-investor demand leads firms to issue larger bonds with lower yields, longer maturities and fewer investor protections. This suggests the shift to passive investing may be contributing to increased corporate leverage by encouraging firms to issue corporate bonds that will be included in indexes.

The removal of assets from an index causes their prices to fall. This may affect financial stability because of the recent shift in the ratings distribution of investment-grade bonds towards triple-B, the lowest investment-grade rating. About 50 percent of investment-grade corporate bonds outstanding had triple-B ratings as of March 2019. In an economic downturn, widespread downgrades of these bonds could push them out of investment-grade status, rendering large numbers of bonds inappropriate as investments for investment-grade corporate bond mutual funds, leading to widespread bond sales that exacerbate any price declines due to the downgrades themselves.

The liquidity for investment-grade bonds has declined, but it has increased for high-yield bonds.

Summary

The proponents of active management will continue to attack passive investing. The reason is simple: It threatens their livelihood. Thus, their behaviour should not come as a surprise. You are best served by treating such attacks as nothing more than propaganda. And you can be confident that the trend toward passive investing will continue because it is the winning strategy, providing you with the greatest odds of achieving your financial goals.