Passive investment vehicles have been expanding rapidly over the past 10 years, with assets reaching about USD8 trillion or 20% of aggregate investment funds last year. ETFs alone now account for 14% of fund assets. Beyond, the share of informal passive investing, such as ‘closet indexing’, is probably even larger. The plausible consequences of the passive investment boom include [i] less information efficiency of markets, [ii] greater incentive for low-quality issuance and corporate leverage, [iii] greater price correlation across securities, and [iv] stronger transmission of financial shocks into emerging economies.

Sushko, Vladyslav, and Grant Turner (2018), “The implications of passive investing for securities markets”, BIS Quarterly Review, March 2018
Converse, Nathan, Eduardo Levy-Yeyati and Tomas Williams (2018), “How ETFs Amplify the Global Financial Cycle in Emerging Markets”, Institute for International Economic Policy, IIEP-WP-2018-1

The post ties in with SRSV’s summary lecture on macro information efficiency, particularly the section “Why markets are not (macro) information efficient”.

The below are mainly excerpts from the Sushko and Turner paper. Quotes from Converse, Levy-Yeyati and Williams have been explicitly marked. Emphasis and cursive text have been added.

The rise and size of passive investment

“Passive portfolio management (or passive investing) is a strategy that tracks the returns of a price index, such as an established market benchmark. It is typically implemented by holding each of the indices’ constituent securities in line with their representation in the index. Maintaining a passive investment strategy requires no trading in the absence of changes in index composition.”

“The mutual fund industry has grown rapidly over the past fifteen years and now manages 40 trillion U.S. dollars in assets worldwide…Within the fund industry one of the most notable developments in the past decade has been the growth of passively managed funds and exchange-traded funds (ETFs). The assets held by ETFs have increased even more rapidly than those of the industry as a whole, so that ETFs’ share of fund assets has gone from only 3.5% in 2005 to 14% in 2017.” [Converse, Levy-Yeyati and Williams]

“Passive fund assets have expanded rapidly over recent years and now represent a significant portion of the global investment fund universe. Measuring industry size by assets under management, passive funds managed about $8 trillion or 20% of aggregate investment fund assets as of June 2017, up from 8% a decade earlier. Passive (or index) mutual funds, the traditional passive portfolio product, grew sharply over this period. ETFs, which allow intraday trading of shares in passive portfolios on a secondary market, grew even faster. ETFs’ share of passive fund assets exceeded 40% in June 2017, compared with around 30% in 2007.”

“Growth in passive funds has been rapid for both equity and bond asset classes [centre panel below]. The rising popularity of passive equity funds has displaced investment in their active counterparts, which experienced outflows over the past decade [right-hand panel below]… Across countries, passive funds have gained most prominence in US equities…There, they have expanded to more than $4 trillion, or 43% of total US equity fund assets… Sharp rises in the proportion of passive funds have also occurred for European and emerging market economy equity funds.”

“Using assets managed by index tracking funds is [probably understating]…passive investing…The risk of outflows if they underperform their benchmark leads many active funds to avoid portfolios that deviate substantially from those of the market index…In many countries the share of ‘closet indexing’ (where weights of securities in equity fund portfolios are not substantially different from those of the benchmark) is more or less the same as that of ‘explicit indexing’, if not higher. Closet indexing is also prevalent among actively managed bond funds, particularly those investing in emerging economies. Furthermore, other investors, such as pension funds and insurance companies, may implement passive investment strategies in their portfolios managed in-house.”

The logic behind passive investment and its expansion

“Actively managed funds…seek to earn higher returns than their chosen benchmark through discretionary security selection or trading in anticipation of market turning points. Doing so generates trading costs and requires compensation to active managers and investment in relevant information, which go hand in hand with higher fees.”

Passive investing can…be considered an optimal strategy to the extent that outperformance of the market benchmark is a ‘zero sum game’. Since passive investors’ average return before costs should, by construction, equal the market return, the average return across all active investors must also equal the market return. Given that active investors are attempting to beat the market, any gains for some of these investors must be offset by the losses of others. Thus, after trading costs, the average return for active investors will be less than for passive ones.”

“After fees and expenses, most active equity funds have failed to outperform the market benchmark in recent years [see graph below, left-hand panel]. Moreover, at least in major markets, funds that outperformed their benchmark have not done so consistently.”

“The recent popularity of lower-cost passive funds has been supported by structural shifts in the financial advisory industry. These include: the rise of the so-called ‘robo advisors’ (platforms offering low-fee automated investment management services); the introduction of fiduciary duty requirements; and a move away from commission-based remuneration. Regulators’ greater focus on fee transparency has also played a role in some jurisdictions.”

“The bulk of money flowing into passive funds over recent years has been directed to the largest fund managers, which tend to offer the lowest-cost funds. Since 2010, the three largest passive fund managers have received around 70% of cumulative inflows. This pattern of inflows can set in motion scale economies that help compress fees. Greater fund size mechanically reduces funds’ expense ratios and allows managers to further invest in cost reductions and new products, in turn helping them to attract more inflows.”

The consequences of large and rising passive investment

“An increase in the share of passive portfolios might reduce the amount of information embedded in prices, and contribute to pricing inefficiency and the misallocation of capital… passive portfolio managers have scant interest in the idiosyncratic attributes of individual securities in an index. They do not devote resources to seeking out and using security-specific information relevant for valuing individual securities…At some point, greater anomalies in individual security prices would be expected to increase the gains from informed analysis.”

“Passive investing may alter the relationship between issuers and investors. By design, passive funds invest in all securities included in the index they track. Unlike active investors, they cannot express their disagreement with the decisions of individual issuers by selling their holdings. A higher share of passive investors could therefore weaken market discipline and alter the incentives of corporate and sovereign issuers to act in the interest of investors…Growth of passive bond funds, specifically, might encourage leverage by borrowers. Because inclusion in bond indices is based on the market value of outstanding bonds…the largest issuers tend to more heavily represented in bond indices. As passive bond funds mechanically replicate the index weights in their portfolios, their growth will generate demand for the debt of the larger, and potentially more leveraged, issuers…Regression results confirm that there is a statistically significant positive relationship between a company’s weight in the index and its leverage (based on either total debt or just bond debt).”

“An increase in passively managed portfolios could also affect the pricing of securities through greater portfolio-wide trading in the market. Passive managers buy and sell the entire basket of index constituents in response to fund inflows and outflows. This trading pattern can induce higher co-movement in the prices of the constituents of the index…Greater co-movement of securities in an index implies a reduction in the potential benefit of holding the diversified portfolio…Discernible effects are evident when individual stocks are included in the S&P 500 index: their correlation with the index increases, trading volume jumps and bid-ask spreads narrow.”

“We show that the growing role of ETFs as a channel for international capital flows has amplified the transmission of global risk shocks to emerging economies…First, we present robust evidence that fund level investor flows to ETFs respond more to global risk shocks than do flows to traditional mutual funds. By contrast…ETF flows respond much less, if at all, to changing economic conditions in the countries in which the funds invest. Second, we show that where ETFs hold a larger share of the host country’s market capitalization, aggregate portfolio flows are more sensitive to global factors. These findings indicate that the rise of ETFs as a conduit for international capital flows has amplified the effects of the global financial cycle in emerging markets.” [Converse, Levy-Yeyati and Williams]

Annex: Understanding ETFs

“Like passive (index) mutual funds, exchange-traded funds (ETFs) seek to track the returns of a benchmark index. The key innovation of ETFs is a trading process that combines the characteristics of open-end mutual funds with those of closed-end funds. Variation in the number of ETF units arising from inflows or redemptions resembles the design of open-end mutual funds, while the ability to trade ETF shares throughout the day on a secondary market at a transparent price is a feature shared with closed-end funds. Trading of ETF shares on an exchange also allows market participants to place market, limit or stop orders, as well as to engage in short selling, which further boosts the ETFs’ market liquidity.”

“ETFs’ unique primary-secondary market trading mechanism is facilitated by registered intermediaries known as authorised participants (APs), typically broker-dealers or market-makers in the underlying securities. APs may trade the ETF shares on the secondary market like other investors, but they can also create and redeem ETF shares (known as “creation units”) through direct transactions with the ETF sponsor at the current net asset value of the portfolio. The ability of APs to transact in both the primary and the secondary market incentivises profitable arbitrage of the ETF share price and the underlying assets. This, together with arbitrage by other market participants solely in the secondary market, underpins a key value proposition of ETFs for investors – near-immediate liquidity at a share price close to the value of assets underlying the price index. This can be contrasted with open-end mutual funds, where investors buy or redeem units directly at the fund’s end-of-day net asset value.”

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Ralph Sueppel is founder and director of SRSV Ltd, a research company dedicated to socially responsible macro trading strategies. He has worked in economics and finance for almost 25 years for investment banks, the European Central Bank and leading hedge funds. At present he is head of research and quantitative strategies at Macrosynergy Partners.