LONDON (Reuters Breakingviews) - Inflows into exchange-traded funds (ETFs) approached $500 billion last year, according to ETF.com. Even with February’s market ructions, another $64 billion arrived in just the first two months of the year. The rapid growth of these index-linked financial products is “worse than Marxism”. So argued the analysts at Bernstein back in the summer of 2016. Bernstein claimed that investors who adopt passive strategies are free-riders who abrogate their responsibility to allocate capital intelligently. The research firm may have a point. But a more pressing, and less widely aired, concern is the threat posed to financial stability by the newfound dominance of benchmark-tracking funds.
The growth of passive – that’s to say, investment in index funds – at the expense of traditional “active” asset management has been remarkable. Bernstein reckons that over the past decade some $5 trillion globally has flowed from active to passive, most of which has gone into ETFs. Even more noteworthy has been the explosion in the number of investment indexes. Back in 2012, around 1,000 benchmarks were on offer, including the venerable Dow Jones Industrial Average, the S&P 500 Index, the FTSE 100, and so forth. At the latest count, this figure had grown to over 3 million, according to the Index Industry Association. Standard & Poor’s now has a million indexes to choose from. MSCI, a competing outfit, produces nearly a couple of hundred thousand more.
Many of these new indexes offer enhancements to traditional market benchmarks. There has been a proliferation of multi-factor indexes, such as the MSCI USA Minimum Volatility Index. Just about anything that can be indexed has been or will be. Want exposure to cannabis? There’s the Emerging Marijuana Growers Index (one of whose top holdings sports the ticker WEED). Want to add diversity to your portfolio? There’s the MSCI Women’s Leadership Index. Yet, as Bernstein points out, there are only 43,000 stocks listed globally and a mere 3,000 of them are liquid. This makes for an “absurd superabundance” of indexes, says Bernstein.
The mania for index funds isn’t merely to do with their low fees. They have performance on their side. Only about one in 10 U.S. active funds has recently managed to beat the index, says strategist Gerard Minack.
The era of ultralow interest rates and quantitative easing hasn’t been kind to stock pickers. Value-oriented investors have been left behind by soaring stock markets. Their preferred habitat of low-valuation stocks has underperformed while more expensive stocks have benefited from easy money (a lower discount rate applied to their distant future earnings has given growth, or “momentum”, stocks a relatively greater boost). Active managers, unlike ETFs, sit on piles of cash. This has served as an extra drag on performance during the long bull market, especially when real interest rates have been negative.
As passive investing has taken off, the stocks most in demand have been those with the largest weightings in the most popular indexes. This explains why the S&P 500 Index has become increasingly concentrated in a few dozen large capitalisation, or “mega-cap”, stocks, including familiar names such as Amazon, Microsoft, Exxon Mobil, and so forth. Investors who deviate from the benchmark index are doomed. No wonder institutional and retail investors alike have deserted their old fund managers to embrace the passive world. Around 40 percent of U.S. equity assets under management are now indexed. Credit Suisse reckons that passive penetration among institutional investors in American stocks is as high as 60 percent.
But is this too much of a good thing? Several well-known investors believe so. Jeffrey Gundlach of DoubleLine Capital complains that passive is really investment by committee, namely by those who select the index components. Howard Marks of Oaktree Capital bemoans a market on autopilot, with stocks being blindly acquired by index funds. Bernstein writes that “a supposedly capitalist economy where the only investment is passive is worse than a centrally planned economy” since the functions of price discovery and capital allocation are neglected. At least the Soviet bureaucrats attempted to allocate resources, however badly that turned out.
Exponents of index investing, including Princeton University economist Burton Malkiel, author of the best-selling “A Random Walk Down Wall Street”, will have none of this. They adamantly reject that passive investment has had any negative impact on capital allocation. After all, there are still many investors, including Gundlach and Marks, who are extremely well incentivised to keep share prices in line with fundamentals. Malkiel sees no reason why the market share of active managers shouldn’t fall below 10 percent.
The trouble is that once passive utterly dominates the investment world it poses a threat to financial stability. This is because index funds only trade when they receive inflows and outflows. They don’t provide market liquidity, unlike active investors who use their cash to buy and sell when they think the price is right. As passive investment grows it siphons liquidity out of the market. This effect is not yet evident because large inflows into index funds during the bull-market years have provided a countervailing source of liquidity.
What would happen once 90 percent of the market is owned by passive vehicles? At that point, if investors attempted to liquidate, they could soon run into trouble. Since ETFs don’t hold any cash of their own they would have to meet redemptions by selling shares. But they might find there’s nobody left on the other side of the trade. A tiny fraction of passive sales would overwhelm the buying power of the remaining active investors. At that point, the stock market would crash. This also works in reverse. Small inflows into passive funds could cause the market to melt up. Either way, volatility spikes.
The safe upper limits for passive investment may already have been surpassed. Back in late August 2015, after China’s surprise currency devaluation, ETFs experienced a sudden “flash crash”. The arbitrageurs who normally keep these index funds in line with the cash market suddenly disappeared. Many ETFs briefly traded at major discounts to net asset value. Since then, the advance of blind capital in the financial world has been phenomenal. On the U.S. stock exchanges, ETFs account for around 30 percent of daily trading volume. When cash inflows into passive investments are replaced by outflows, a volatility shock beckons.
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