The growth of passive investing has been one of the biggest, indeed arguably the single biggest, development in the asset management industry in recent years. But some observers have expressed concern that indexing has now grown too big and that it’s starting to distort market prices. So is there any truth in it? PATRICK CAIRNS weighs up the evidence.
The inexorable rise of indexing since the global financial crisis has been truly extraordinary. According to research by the Investment Company Institute (ICI), more than $2 trillion has moved out of active funds and into passive funds over the past ten years in the US alone. Passive funds now hold a higher percentage of the US stock market than active funds.
This has been an incredible shift, brought about by passive’s obvious benefits to investors: lower fees, more transparency, and easy access in the case of ETFs.
However, not everyone has been that pleased about it. Many people in the investment industry continue to argue that passive investing has some serious problems.
Free-riding on the efforts of active investors
The most serious criticism of passive investing is that it distorts market prices. Because broad-index passive funds buy a whole portfolio of stocks at once — the whole S&P 500, for example — rather than individual shares, they don’t care about the price they are paying.
As a 2018 paper by Vladyslav Sushko and Grant Turner noted:
“[Passive funds] do not devote resources to seeking out and using security-specific information relevant for valuing individual securities. In effect, they free-ride on the efforts of active investors in this regard. Hence, an increase in the share of passive portfolios might reduce the amount of information embedded in prices, and contribute to pricing inefficiency and the misallocation of capital.”
There have been a number of empirical studies that also show what effects this has. When a share is added to the S&P 500, for example, there is evidence that its price goes up since index funds have to buy it. In addition, its movements become more correlated to the index, and bid-ask spreads narrow.
But how big is index investing in reality?
However, just because there is evidence that passive funds do have an affect on market prices, doesn’t mean that that effect is either significant or dangerous.
Firstly, that is because even in the US, where the growth of passive investing has been strongest, they still hold only a relatively small share of the whole market. Research by ICI shows that passive funds owned 16% of the US stock market at the end of last year.
It would defy mathematics for funds that own just one sixth of the market to dominate the other five sixths. But even more importantly, prices are only set when shares are traded. Just by owning shares, passive funds are not having any influence at all. They only have an influence when they trade.
And passive funds account for only a fraction of the trading on stock markets. BlackRock, Vanguard and Morningstar have all conducted analysis that has found that index managers – in both ETFs and index funds – account for less than 5% of trading volume on any given day.
Many passive funds also only trade once a day, at the market close. They don’t trade during the day, which is when most of the price-setting activity takes place.
The growth of passive investing is actually good for markets
Another important consideration is where the money that has gone into passive funds has come from. If investors are turning to passive funds rather than trying to invest in stocks themselves, this is actually good for markets.
As Nobel laureate Eugene Fama and Kenneth French wrote in a 2009 blog, titled Q&A: What if Everybody Indexed?:
“If misinformed and uninformed active investors (who make prices less efficient) turn passive, the efficiency of prices improves. If some informed active investors turn passive, prices tend to become less efficient. But the effect can be small if there is sufficient competition among remaining informed active investors.”
Has indexing made markets less efficient, or more?
And there is a lot of evidence that shows that passive funds have, in fact, not had a materially negative impact on market efficiency.
If, for example, it were true that passive investors were distorting prices, then you would expect them to be distorting the prices of all the stocks in an index in a relatively similar way. However, it’s quite obvious that not all of the stocks in the S&P 500, for instance, go up and down together.
Analysis by Dimensional Fund Advisors found that in 2017, for example, the S&P 500 gained 21.8%. There were significant inflows into passive funds over this period. Yet, the best-performing share in the index went up 133.7%, and worst fell -50.3%.
There were substantial differences in performance even between stocks that had the same weighting in the index. That year, Amazon’s share price rose 56.0% and General Electric’s dropped -42.9%, even though they both made up about 1.5% of the S&P 500.
Did the growth of passive investing contribute to the bull market?
Recently, some critics of passive investing have also been caught up by their own arguments.
Last year, Vincent Deluard, a global macro strategist at the brokerage StoneX, published research that claimed that passive investing was a big part of the reason why stock prices had risen so much in recent years and become so disconnected from fundamentals.
“A preponderance of evidence suggests that the rise of passive has played a major role in the stock market bubble of the past decade,” Deluard told the Financial Times. “If the rise of passive is the main cause for this bull market, a sustained bear market can only occur if the passive sector shrinks.”
The US market has now recorded three straight negative quarters in 2022. That is the worst series of quarterly returns since the 2008 global financial crisis.
Yet, the passive sector has not shrunk over this time. Therefore, by Deluard’s own argument, it cannot be the main cause of the bull market that preceded it.
What about closet index funds?
A final reason why the argument against passive funds becomes questionable is that, in reality, there are active managers who have been running ‘closet index’ funds for decades. These are supposedly active funds, but which effectively track an index.
A 2016 study by Martijn Cremers and others found that “about 20% of the worldwide mutual fund assets are managed by closet indexers”. This is a practice that has gone on for a very long time, without anyone ever questioning whether the managers of these funds were distorting markets.
The reality is that markets work because whenever mispricings do appear, that creates an opportunity for someone else to exploit.
Investors can therefore rest assured: the impacts that passive funds have on share prices are not going to disrupt markets in an unsustainable way as long as there are active investors willing and able to trade around them.
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