Are Index Funds Threatening Market Efficiency? – ValueWalk Premium

Are Index Funds Threatening Market Efficiency?

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This article originally appeared on ETF.COM here.

Over the past few decades, there has been a substantial shift from active to passive investment strategies.

Active strategies give managers discretion to select individual securities and/or time the market, generally with the investment objective of outperforming a previously identified benchmark.

Passive strategies (such as indexing) use rules-based investing to track an index, typically by holding all its constituent assets or an automatically selected representative sample of those assets.

Kenechukwu Anadu, Mathias Kruttli, Patrick McCabe, Emilio Osambela and Chaehee Shin of the Risk and Policy Analysis Unit of the Federal Reserve Bank of Boston explore the potential financial implications of the active-to-passive shift in their January 2019 working paper “The Shift from Active to Passive Investing: Potential Risks to Financial Stability?

Passive shift is global

They began by noting: “Passive funds made up 45% of the assets under management (AUM) in equity funds and 26% for bond funds at the end of 2017, whereas both shares were less than five% in 2005.” They also noted that the shift to passive investing has occurred in other countries as well.

The shift to passive strategies has been fueled by the findings (such as those in the year-end 2018 SPIVA report) from research demonstrating that few active funds persistently outperform their risk-adjusted benchmarks and by the lower costs and greater tax efficiency of passive strategies.

The authors note: “The shift has sparked wide-ranging research and commentary, including claims about effects on industry concentration, asset prices, volatility, price discovery, market liquidity, competition, and corporate governance.”


The purpose of their study was to examine the potential repercussions of the active-to-passive shift on:

  1. Effects on funds’ liquidity transformation and redemption risk, particularly in the mutual fund and ETF sectors
  2. Growth of passive investing strategies that amplify volatility
  3. Increased asset management industry concentration
  4. Changes in asset valuations, volatility and co-movement

Following is a summary of their findings:

  • The growth of ETFs, which are largely passive vehicles that do not redeem in cash (ETFs redeem shares in-kind), has likely reduced risks arising from liquidity transformation in investment vehicles. As of March 2018, ETFs that redeemed exclusively in-kind accounted for 92% of ETF assets, reducing the likelihood that large-scale redemptions would force funds to engage in destabilizing fire sales. In addition, there is evidence that passive mutual funds are less likely to hold highly illiquid assets that contribute to liquidity transformation risks. For example, as of the end of 2017, passive funds made up just 0.006% of the AUM of the relatively illiquid U.S. high-yield bond and bank-loan sector compared to 25% of assets in the investment-grade corporate bond sectors.
  • Investor flows for passive mutual funds are less reactive to fund performance than the flows of active funds. Thus, passive funds may face a lower risk of destabilizing redemptions in episodes of financial stress. For example, from December 2007 through mid-2009, passive funds had cumulative inflows and active funds had aggregate outflows.
  • Some passive investing strategies, such as those used by leveraged and inverse exchange-traded products, amplify market volatility through their rebalancing activity. These funds must trade in the same direction as market moves that occurred earlier in the day, buying assets (or exposures via swaps or futures) on days when asset prices rise and selling when the market is down.

Read the full article here by by Larry Swedroe, Advisor Perspectives

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