The share of passive investment vehicles in financial markets has soared over the past 20 years. In the U.S. equity market it has risen from 12% to 46%. There is reason and evidence suggesting that this will lead to more market price distortions. First, index effects on prices have gained importance relative to other price factors. Second, there has been a reduction of differentials across equity returns within indices. And third, the rise in passive investment vehicles has coincided with the expansion of momentum strategies in active funds, giving rise to vast flows that all explicitly neglect fundamental value.

FTSE Russell, “The growth of passive investing: Has there been an impact on the US equity market?”, September 2017

The post ties in with SRSV’s lecture on price distortions, particularly the section on “Price Distortions and rebalancing rules.”
The below are excerpts from the paper. Emphasis and cursive text have been added.

What is passive investment?

“It is critical to distinguish between passive investing per se and specialized investment…vehicles that are used as means to invest in index-based products…We define passive investing as investment in an open-ended mutual fund (OEF) or an exchange traded fund (ETF) that is designed to replicate or accurately track the performance of a capitalization-weighted index of a market or market segment.”

“We exclude from our definition of passive investing…smart beta index-based OEFs and ETFs, including funds tracking alternatively-weighted market indexes…and… stock index derivatives to gain exposure to stock indexes, including the use of stock index futures; options; options on futures; index swaps; and other structured products.”

The rise of passive equity investment vehicles

Passive market share of ETFs and open-ended mutual funds (OEFs) has grown from 12% in January 1998 to 46% at the end of December 2016. ETFs represented 4% of the passive component at the start of 1998, but by the end of our period, December 2016, had grown to 46%. A large part of the recent growth in passive assets, thus, has been in ETFs.”

“The rate of growth in the passive market share in US equity investing has been increasing over time…The average yearly increase for the first 10 years (1998 to 2007) was 1.18%; from 2008 to 2016, the average increased to 2.44% even with 2009 included, the one year in our sample that passive market share declined.”

“At the beginning of the sample period the passive market share for ETFs was 4%; by its end that share had grown to 40%. Thus, a notable proportion of the growth of overall passive investing in the US equity market has been in ETFs. ETFs differ from OEFs in many ways; perhaps the most significant are that they are listed on exchanges, are priced and can be traded throughout the day, and have preferential tax treatment.”

Index effects

Issues of price distortion are in the forefront of…concern about the growth of passive investing…Purchases and sales of stocks by passive investors are not based on the idiosyncratic characteristics of individual companies; passive investors do not buy or sell shares based on evaluations of company actions or projected changes in value; passive investors buy and hold…all the constituents of a given index at the weights and prices the market dictates. They buy new stocks when they enter their benchmark at the market price and in the weight determined by the index methodology…and only sell in the event that a stock is no longer eligible for index inclusion. Index-based funds are — with the exception of rebalancing and reconstitution events — buy-and-hold investment vehicles.”

“Active investors discriminate among stocks and enterprises, and in so doing contribute a service to the market and the economy by allocating capital to companies based upon evaluations of the future worth of their projects. This activity theoretically guarantees that observable market prices are in sync with expected present value…Since passive investment vehicles are by definition not active, i.e., they do not buy and sell stocks based on forecasted performance, the argument is that price discovery is inhibited by passive investing that impairs the market’s ability to determine fair value, and thus allocates funds indiscriminately across companies.”

“There is abundant research both academic and practitioner on the pricing effects…

  • [Academic research] estimated an average 9% jump in valuations for stocks newly added to [the S&P 500] index, while stocks that are removed suffered an even greater loss in price. This is far in excess…to any premiums/discounts due to increased/decreased liquidity impacts from inclusion/exclusion in the index.
  • Stocks entering the Russell 2000 index tend to carry a premium, whereas those moving up from the Russell 2000 Index enter the Russell 1000 index at a discount.
  • More passively invested assets exhibited greater pricing anomalies than their actively-invested counterparts.
  • More passively held stocks exhibit greater inefficiency in terms of deviation of price behavior from a random walk and increased duration of post earnings announcement price drift.”

Declining return dispersion

Cross-sectional return dispersion measures the extent to which stock returns differ at a given point in time…across a market; in other words, the extent to which investors as a whole are making distinctions among companies in terms of changing prices during a given time period… A growing consensus acknowledges that lower levels of dispersion means a reduced opportunity set for active managers.”

“We calculate US equity dispersion as of each month end as the standard deviation of that month’s returns across all stocks in the Russell 1000 Index….The [below chart] does show… a general decline in the level of dispersion, but we see that there are notable spikes even in the most recent period, indicating that there are still times when investors are making sharp distinctions in pricing stocks.”

“A linear regression defining the market share of passive assets as the independent variable and US equity dispersion as the dependent variable reports that the coefficient for dispersion is strongly statistically significant…The coefficient is negative, indicating that there is a negative relationship (a decline) in dispersion associated with the increase of passive assets.”

Neglect of fundamental value

“The increase in passive market share has raised concerns about whether passive investing has damaged…the market’s ability to define accurate prices…[and] decoupled [prices] from fundamental value;…But [also] active management is no longer solely focused — if it ever was — on fundamentals [due particularly to]…the growth of momentum investing strategies within the active management industry.”

Momentum can be used just as a term for performance chasing, or it can mean a specific factor construction…Technical analysts and investors tend to have short horizons, although there is a great variety in approaches across that part of the investment world. In academic and sophisticated practitioner circles, for equities, the momentum measurement is commonly the last 12 months less the most recent month.”

“The growing evidence regarding momentum premiums since the 1990s along with academic work on behavioral finance has allowed for a greater acceptance of these strategies by investors. Momentum has always been a core aspect of technical investing, but it has grown in importance and acceptance…due to the evidence of momentum factor existence and behavior. Hedge funds in particular have been reported as pursuing momentum strategies. While passive investing may have built within it a bias toward momentum, active investors are now deliberately targeting momentum as an investment strategy. If momentum presents a growing problem for the market, it has multiple roots; it is not just a function of passive market share.”