THE LONG VIEW - How passive investors morphed into the bad guys

14 October 2017

 Markets are suffering from a serious case of passive aggression. Or at least that is what many now believe.

Passive investing - in which funds merely match an index and make no active attempt to choose stocks or other securities - has transformed markets over the past 25 years. In the US more than a third of stock funds assets are passive, while index funds dominate flows of new money into the market.

Passive investing can be done more cheaply than active investing, which requires spending on research and salaries. This gives it an advantage. And as institutions have come to dominate trading in markets, so the markets’ judgments grow more efficient. That makes traditional “active” management ever harder - few stocks are so obviously mispriced that investors can confidently expect them to beat the index. As more and more investors work this out, so passive investing has boomed.

Now that passive investors have become the giants they have morphed from the good guys to the bad guys. (rather like the giant companies of the internet). They now face questions over whether their scale is such that they are distorting the market.

The issue sharply divides opinion. The case against passive investing breaks down into two arguments. First, because passive owners will hold a given stock as long as it stays in an index, they have no incentive to take an active voice in the company, and no means to threaten the management. Thus passive management means weak stewardship and weaker corporate governance.

Three groups, BlackRock, Vanguard and State Street, dominate passive investing, and all of them insist that passive investing makes them even more assertive stewards. The argument is that as they cannot sell, the only way they can improve their returns, is by taking an active role when voting their shares.

Managements are dubious. One chief executive told me: “We’d love to talk to the passive guys, they control 20 per cent of our shares, but they don’t want to see us.”

Beyond stewardship, another argument concerns price discovery. As index buyers are price-insensitive, the argument is that they thwart the process of setting an accurate price for a stock taking into account all known information.

In particular, as money flows into indexed mutual funds or ETFs, so an increasing share of those flows will go to those stocks that have risen in value. By trusting the price that the market has put on stocks, this argument claims, index funds overweight the stocks that are overvalued and underweight those that are undervalued. Active managers try to do the opposite.

Stocks have a tendency towards “momentum” - winners keep winning and losers keep losing. Momentum strategies in the US are having a banner year, with MSCI’s momentum index beating the market as a whole by almost 12 per cent. The equivalent value index, containing stocks that look cheap compared to their fundamentals, is lagging the market by more than 5 per cent.

This is serious. Misallocated capital has negative results for everyone in the economy. But is it true? Victor Haghani of Elm Capital believes strongly that it is not. “Flows into a broad index fund create purchases proportional to the size of each company,” he said. “The market impact of buying $100m in one company, and $25m in a company a quarter the size, should be identical.”

It is hard, therefore, to see how it can boost momentum towards the bigger stocks. Meanwhile, he says, the argument that indexing makes the market less efficient “implies that you are taking it away from the good managers”. Poor performance by active managers has been key to passive funds’ appeal, so this is hard to believe.

Against this, many in the market say that belief in a “Passive Put” is indeed affecting behaviour. The presence of the indexers, and the use of benchmarks to judge active managers’ performance, changes everyone’s behaviour.

Mark Lapolla points out that ETFs make it easier to manage risk. If investors fear a downturn, they can sell or short an ETF. As Wall Street’s risk management systems tend to work from the same assumptions, this leads to the risk of syncopated co-ordinated selling - which would, in turn, drive prices down.

Paul Woolley, who heads the London School of Economics’ centre for the study of market dysfunction, argues that moving to passive involves selling stocks which tend to have been losing. and buying winners. It aids momentum. Meanwhile, almost all active managers now compare themselves to index funds, which clients regard as the prime competition. If the weight of a stock in the index goes up, it grows riskier for an active manager’s career to stay out of it. So they buy, pushing up the price, so its index weight rises. Rinse and repeat.

The debate should continue. But like Facebook or Google in the internet, passive funds must prepare to answer questions about their impact on the market.


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Copyright The Financial Times Limited 2017

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