Here’s a surprising – and possibly alarming – fact. According to Bloomberg, the US now has nearly 5,500 market indices. These indices outnumber the 4,000 or so listed US companies. The exponential rise in the number of indices has been driven by a tsunami of money pouring into “passive” investing. Needless to say, some market commentators are getting concerned.
While a substantial amount of the $1.7 trillion of passive inflows since 2007 have flown into traditional indices such as the S&P 500, over $600 billion has gone into smart-beta strategies, which now account for a quarter of all US passive equity assets.
The idea that passive strategies distort markets has been debated at both the academic and practical level for years, and has flared in recent times due to the acceleration of passive inflows combined with ever-frothier stock prices. The main concern of active investors is that passive investing reduces price discovery in the market. Passive investors, once they make the decision to enter the market, do so at the prevailing price regardless of fundamentals. If one is buying an asset without regard to the relationship between price and value, then one is at best speculating that a greater fool will come along in the future and bid up the asset’s price. When that asset is the entire US stock market, the loss of price discovery can have dire consequences for the next correction.
A corollary of the above is that ETFs could magnify a market crash. Just as passive inflows have exacerbated the market uptrend by blindly bidding up prices irrespective of valuation, so it logically follows that these stocks (really the whole market, but particularly the S&P 500) will be blindly sold. Passive investors who have been promised abundant liquidity will belatedly realise that ETFs are only as liquid as their underlying assets, and liquidity tends to disappear on the way down just when investors need it most.
At the annual New York Sohn Conference held earlier this month, Jeff Gundlach of DoubleLine Capital warned that there’s no such thing as passive investing. Smart-beta strategies are rules-based with the index provider determining both the rules and which stocks satisfy those rules. I’ve previously written about how ExxonMobil is included in not only the S&P 500, but also in ETFs for active beta, momentum, dividend growth, deep value, quality and total earnings. The implication here is that investors are dumping hundreds of billions of dollars into what they think are passive products, but are really active strategies that exclude the most important investment consideration – price relative to value. And with only ~4,000 stocks to spread across nearly 5,500 equity indices, the magnitude of cross-holdings should result in the correlation of all ETFs and other passive products converging towards 1 during a market event.
Finally, if the unabated rotation into passive strategies isn’t concerning enough, consider that some portion of active managers are in fact closet indexers, whether in a bid to keep their jobs or to rake in management fees. Particularly as active funds get larger and larger (into the tens of billions FUM), their investable universe not only shrinks but progressively overlaps the large cap playground of many ETFs.