Earlier this year, passive management was attacked in two high-profile articles. Those criticisms were proven to be false – and driven by active managers seeking to protect their livelihoods. But that still left the question, which I now examine, of whether flows to passive funds have increased certain risks.
Q3 2019 hedge fund letters, conferences and more
The active management industry has ridiculed passive investing for decades. The reason is that their profits – and their very survival – is at stake. The criticism reached an absurd level when a team at Sanford C. Bernstein called passive investing “worse than Marxism.” The authors of the note wrote: “A supposedly capitalist economy where the only investment is passive is worse than either a centrally planned economy or an economy with active market led capital management.”
Another example of such criticism is the article “What They Don’t Tell You About Passive Investing.” The thrust of that Morgan Stanley paper was that “the exodus from active to passive funds may be reaching bubble-like proportions, driven by an exaggerated critique of active management.”
The basic argument of those and other critiques is that the popularity of indexing/passive investing is distorting prices as fewer shares are traded by active investors performing the act of “price discovery.” Each of those critiques is fallacious.
That said, it’s possible that the trend to passive investing has increased some financial risks.
To determine if that is the case, Kenechukwu Anadu, Mathias Kruttli, Patrick McCabe and Chaehee Shin (all from the Federal Reserve), authors of the September 2019 study “The Shift From Active to Passive Investing: Potential Risks to Financial Stability?” examined how this shift affects financial stability through its impacts on funds’ liquidity and redemption risks, asset-market volatility, asset-management industry concentration, and co-movement of asset returns and liquidity.
The authors began by noting: “The shift to passive investing is a global phenomenon. In the U.S. … the shift has been especially evident among mutual funds and in the growth of exchange traded funds, which are largely passive investment vehicles. Passive funds made up 47% of the AUM in equity funds and 27% for bond funds at the end of 2018, whereas both shares were less than five% in 1995. Similar shifts to passive management appear to be occurring in other types of investments and vehicles. For example, the share of assets under management in university endowments and foundations invested in passive vehicles has reportedly increased substantially in recent years.” They added: “The shift to passive investing is also occurring in other countries.” Following is a summary of their findings:
- The growth of exchange-traded funds (ETFs), largely passive vehicles that do not redeem in cash, has likely reduced risks arising from liquidity transformation in investment vehicles.
- Investor flows for passive mutual funds are less reactive to fund performance than the flows of active funds. The result is that passive funds face a lower risk of destabilizing redemptions in episodes of financial stress. For example, in charting the cumulative flows for equity funds from December 2007 through mid-2009, and the cumulative flows for bond funds during the “Taper Tantrum” in mid-2013, passive funds had cumulative inflows and active funds had cumulative outflows in both cases.
- Passive mutual funds are less likely than active funds to hold highly illiquid assets – holdings of highly illiquid assets can create severe liquidity risks for funds that offer daily redemptions.
- Leveraged and inverse ETFs, which seek daily returns that are respectively positive and negative multiples of an underlying index return, must both trade in the same direction as the market moved earlier in the day. Thus, they must buy assets (or exposures via swaps or futures) on days when asset prices rise and sell when the market is down, amplifying market volatility.
- Since passive funds use indexed-investing strategies, these funds’ growth could contribute to “index-inclusion” effects on assets that are members of indexes, such as greater co-movement of returns and liquidity. They added that the research found that the effects of index inclusion had declined significantly since 2000. In addition, equity co-movement has declined significantly since 2000.
- Stocks with more ownership by ETFs display higher volatility than otherwise similar securities. The volatility arising from ETF trading induces a non-diversifiable source of risk, at least in the short term. However, while ETF trading may lead to pricing distortions for individual ETF-held securities, such trading helps move aggregate market prices closer to fundamentals.
- Research has found that passive-investor demand leads firms to issue larger bonds with lower yields, longer maturities and fewer investor protections. This suggests the shift to passive investing may be contributing to increased corporate leverage by encouraging firms to issue corporate bonds that will be included in indexes.
- The removal of assets from an index causes their prices to fall. This may affect financial stability because of the recent shift in the ratings distribution of investment-grade bonds towards triple-B, the lowest investment-grade rating. About 50% of investment-grade corporate bonds outstanding had triple-B ratings as of March 2019. In an economic downturn, widespread downgrades of these bonds could push them out of investment-grade status, rendering large numbers of bonds inappropriate as investments for investment-grade corporate bond mutual funds, leading to widespread bond sales that exacerbate any price declines due to the downgrades themselves.
- The liquidity for investment-grade bonds has declined, but it has increased for high-yield bonds.
Read the full article here by Larry Swedroe, Advisor Perspectives
