May 08, 2019
‘Passive’ Market Efficiency Works
Over the past few decades, there has been a substantial shift from active to passive investment strategies.
Active strategies give managers discretion to select individual securities and/or time the market, generally with the investment objective of outperforming a previously identified benchmark.
Passive strategies (such as indexing) use rules-based investing to track an index, typically by holding all its constituent assets or an automatically selected representative sample of those assets.
Kenechukwu Anadu, Mathias Kruttli, Patrick McCabe, Emilio Osambela and Chaehee Shin of the Risk and Policy Analysis Unit of the Federal Reserve Bank of Boston explore the potential financial implications of the active-to-passive shift in their January 2019 working paper “The Shift from Active to Passive Investing: Potential Risks to Financial Stability?”
Passive Shift Is Global
They began by noting: “Passive funds made up 45% of the assets under management (AUM) in equity funds and 26% for bond funds at the end of 2017, whereas both shares were less than five% in 2005.” They also noted that the shift to passive investing has occurred in other countries as well.
The shift to passive strategies has been fueled by the findings (such as those in the year-end 2018 SPIVA report) from research demonstrating that few active funds persistently outperform their risk-adjusted benchmarks and by the lower costs and greater tax efficiency of passive strategies.
The authors note: “The shift has sparked wide-ranging research and commentary, including claims about effects on industry concentration, asset prices, volatility, price discovery, market liquidity, competition, and corporate governance.”
The purpose of their study was to examine the potential repercussions of the active-to-passive shift on:
1. Effects on funds’ liquidity transformation and redemption risk, particularly in the mutual fund and ETF sectors
2. Growth of passive investing strategies that amplify volatility
3. Increased asset management industry concentration
4.Changes in asset valuations, volatility and comovement
Following is a summary of their findings:
- The growth of ETFs, which are largely passive vehicles that do not redeem in cash (ETFs redeem shares in-kind), has likely reduced risks arising from liquidity transformation in investment vehicles. As of March 2018, ETFs that redeemed exclusively in-kind accounted for 92% of ETF assets, reducing the likelihood that large-scale redemptions would force funds to engage in destabilizing fire sales. In addition, there is evidence that passive mutual funds are less likely to hold highly illiquid assets that contribute to liquidity transformation risks. For example, as of the end of 2017, passive funds made up just 0.006% of the AUM of the relatively illiquid U.S. high-yield bond and bank-loan sector compared to 25% of assets in the investment-grade corporate bond sectors.
- Investor flows for passive mutual funds are less reactive to fund performance than the flows of active funds. Thus, passive funds may face a lower risk of destabilizing redemptions in episodes of financial stress. For example, from December 2007 through mid-2009, passive funds had cumulative inflows and active funds had aggregate outflows.
- Some passive investing strategies, such as those used by leveraged and inverse exchange-traded products, amplify market volatility through their rebalancing activity. These funds must trade in the same direction as market moves that occurred earlier in the day, buying assets (or exposures via swaps or futures) on days when asset prices rise and selling when the market is down.
- The shift to passive vehicles has increased asset management industry concentration, with a few large firms (such as Vanguard, BlackRock, State Street, Fidelity and Charles Schwab) dominating the industry, exacerbating potential risks that might arise from serious operational problems at those firms. For example, a significant idiosyncratic event (such as a cybersecurity breach at a large firm) could lead to massive redemptions from that firm’s funds, and thus potentially from the asset-management industry as a whole. Large, sudden redemptions could result in fire sales with broader financial consequences.
- While the growth in indexed-investing strategies could contribute to “index-inclusion” effects on assets that are members of indexes, such as greater co-movement of returns and liquidity, the evidence on trends in comovement and their links to passive investing is mixed.
- While prior research had found that inclusion in the S&P 500 Index led to a 3-4% increase in the stock price, the April 2017 study by Nimesh Patel and Ivo Welch, “Extended Stock Returns in Response to S&P 500 Index Changes,” found that this was no longer the case—the markets were becoming more efficient.
- While stocks with more ownership by ETFs display higher volatility than otherwise similar securities, such trading helps move aggregate market prices closer to fundamentals
- Inclusion in an ETF can increase an asset’s liquidity because it becomes easier to trade as part of the ETF basket—though the liquidity of assets traded individually may decline. For example, ownership is associated with reduced liquidity for investment-grade corporate bonds, but the effect on liquidity is positive for high-yield bonds
- In terms of comovement of returns, adding a stock to the index had a smaller effect on its market beta during the period 2001 to 2012 than in the previous decade, even as indexing had become more common.
Anadu, et al., noted that “If index-related price distortions become more significant over time, they may boost the profitability of active investing strategies that exploit these distortions and ultimately slow the shift to passive investing.” In other words, any problem should be self-correcting by the actions of sophisticated arbitrageurs.
The shift from active to passive investment strategies has profoundly affected the asset management industry in the past few decades. And since the odds of winning the game of active management continue to persistently shrink (for those interested in the evidence and the causes of the phenomenon, see “The Incredible Shrinking Alpha”), the trend toward passive management seems inevitable. Thus, as the authors note: “Its effects will continue to ripple through the financial system for years to come.”
While the active management industry rails against the evils of passive strategies (even declaring it’s “worse than Marxism”), there’s really no evidence that markets are no longer capable of allocating capital efficiently—there is still plenty of room for active funds to set prices.
My guess is that at least 90% of the active management industry could disappear and the markets would remain highly efficient.
Remember, the markets were doing a pretty good job of allocating capital prior to 1950 when the number of mutual funds first topped 100. That number was still only at about 150 in 1960, and we didn’t seem to have any problems allocating capital efficiently then.
Today there are more than 9,000 mutual funds and more than 10,000 hedge funds. Do investors really need all those active managers to ensure that capital is allocated efficiently? It doesn’t seem likely.
There is one other point to make. At least, as of today, the fact that companies who report better- or worse-than-expected results still see higher volumes and larger same-day price moves implies there are still plenty of investors making the markets highly efficient.
This commentary originally appeared March 25 on ETF.com
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