The reaction to the ascent of equity passive investing has been anything but passive. The notion that investors can prosper by mechanically following the rise and fall of the markets — an idea that has mushroomed in popularity in recent decades — has been described as everything from a bubble about to burst to what some analysts have characterized as the “road to serfdom.”1 By this critique, passive investing is about to sweep away active investing, driving analysis and rationality out of the markets. As passive funds continue to pick up market share, some practitioners have also voiced concerns about more-technical issues, ranging from increased correlation risk to the inefficient allocation of capital, distorted valuations and an excessive concentration of equity ownership.1,2
Are these concerns valid? Some of them are, at least in part, though the empirical reality is rarely as simple, or as straightforward, as the critiques. And the problems, which do exist, can be mitigated. Let’s begin with a few persistent misconceptions before we delve deeper into the larger critique of passive investing.
Misconception 1: Passive Funds Dominate the Markets
Although some media outlets tout passive investing’s increasing asset base as evidence of its potential for market distortion, the figures they quote can be misleading. Passive assets are not overtaking the U.S. market — not even close. Passive assets, which include exchange-traded funds (ETFs) and index mutual funds, constitute approximately 15 percent of the total U.S. equity market capitalization, not the 30 to 50 percent, or higher, figure sometimes quoted in the media.
The confusion tends to originate from different definitions of “market share,” which in investment management usually refers to the managed funds industry. This industry is normally defined as the sum of all active and passive mutual funds and exchange-traded funds. But the managed funds industry accounts for about only one third of the entire U.S. equity market. As seen in Figure 1, other market participants collectively dwarf the size of both index funds and active mutual funds.
Internationally, the domestic penetration of passive funds can also be overstated. For example, Japan is often pointed to as a harbinger of the U.S. passive market’s future because 70 percent of the Japanese managed funds market is passive. But this is another misleading figure: Japan’s managed funds industry is less than 25 percent of its equity market, a lower penetration than in the U.S., putting the passive portion of all Japanese equities much closer to the U.S. on a percentage basis than headline numbers suggest.
Misconception 2: Increased ETF Trading Has Been Harmful
Passive ETFs now account for more than 30 percent of U.S. volume on most days, up from about 20 percent in 2006. This rise has troubled some market practitioners, who have blamed the growth in ETF trading for increasing stock correlations and other systemic risks.2,3
Although ETF daily trading volumes have stabilized in the past few years, stock correlations decreased dramatically in 2017, removing a key element of this argument. The S&P 500 index’s intra-portfolio correlation — a measure of how much the companies in the index move together — has dropped below 20 percent in the past year, a level not seen in over a decade.4
The decrease in correlation occurred despite continued increases in passive fund inflows over the same period. One reason for the decoupling of the trends in ETF trading levels versus passive inflows is that most intraday ETF activity is likely active, not passive, trading (either hedging, market making or speculation); previously, such trading may have been accomplished by trading underlying stock baskets. With nearly 400 sector and other narrowly based ETFs launched since 2008, active managers have more tools at their disposal for expressing their views, and for expressing them more cheaply than ever before.
Now that we’ve addressed some misconceptions, let’s examine the empirical evidence for passive investing’s pitfalls.
Pitfall 1: Distorting Market Prices
Does passive investing distort stock prices? The answer in the U.S. appears to be “Occasionally, yes, but so far only in limited circumstances.” Although some evidence exists that passive funds can distort prices in both the short and the long term,5,6 the effects appear to be modest, declining and mostly limited to small-cap stocks and specific sectors.
In the short term, the immediate effect of the annual FTSE Russell reconstitution is underperformance of nearly 18 basis points (bps) per year (though the effect has been declining in recent years), as the company itself noted. This would imply that the true cost of owning the iShares Russell 2000 index (IWM) may be more than the fund’s current 20 bps expense ratio would suggest.
In the longer term, the Russell 2000 stocks trade at higher average price-earnings multiples than their nonindex counterparts in nearly every sector, and they have for every year since 2008 (see Figure 2).
Though this may result in part from other factor exposures among the baskets, as well as index methodology that has evolved over the years, the consistency of the trend since 2008 is worth keeping in mind because a similar tendency doesn’t exist in the S&P 500. Small caps tend to see improved liquidity and analyst coverage when they enter the Russell 2000, and this liquidity premium can persist over longer time frames than the shorter-term effects noted earlier.
Pitfall 2: Rising Auction Costs and Microstructure Distortions
The rise of passive trading has also affected equity markets’ microstructure, most notably in the shift of daily volume trading curves. Since 2005, the end of the trading day has taken on increasing importance in the U.S. Sixteen percent of the daily trading volume occurs in the last half hour; an additional 8 percent happens in the market-on-close (MOC) auctions.7
Much of this migration results from the rise of indexing. Because passive funds benchmark daily valuations to primary exchange closing prices, index fund trading adjustments, such as those attributable to rebalances and fund flows, tend to occur in the relevant exchange’s closing auction in order to receive the official exchange closing prices (or receive broker guarantees to match them). The single, point-in-time auction price allows index funds to minimize tracking error, even if spreading their trades out over the day or longer would minimize market impact. Active funds that engage in closet benchmarking may contribute to this flow; research estimates that closet benchmarkers make up at least 10 percent of all active mutual funds.8
The dictated trading engendered by index methodology has abetted rising closing auction fees at the New York Stock Exchange and Nasdaq, which conduct the closing auctions for nearly all U.S. stocks. Since the NYSE went public in 2006, MOC fees have increased at a faster rate than the intraday spread for the lowest and most basic trading tiers, which exclude volume-based discounts for large traders (see Figure 3). During the day, most U.S. exchanges provide rebates for liquidity providers and charge fees only to liquidity takers, but no such rebate exists in the closing auction, where the two exchanges do not face competition from smaller venues.
Other exchanges, such as those operated by Bats Global Markets, have tried to break this duopoly by offering closing auction alternatives of their own. However, the index methodology for most major indexes still requires pricing at the closing auction price at the exchange where the stock is primarily listed, and that continues to be the NYSE and Nasdaq for the vast majority of U.S. stocks. (Only one S&P 500 stock, Cboe Global Markets, has a primary listing elsewhere. Cboe owns Bats.)
Pitfall 3: Common Ownership Concentration Problems in the U.S.
Quite a bit of recent literature has focused on the effects of rising common ownership concentration at the Big Three index fund managers: BlackRock, State Street Global Advisors and Vanguard Group. These three have more than doubled their ownership share of total U.S. equity capitalization since the onset of the financial crisis, from less than 5 percent to nearly 12 percent (see Figure 4).
With the entire U.S. passive penetration approaching 15 percent of the market, this implies that the Big Three have about 80 percent of the market share of passive assets in the U.S. Combined, the funds also are the largest shareholder of the majority of S&P 500 stocks.
This concentration occurs even though each fund manager tracks a variety of different indexes. For example, over the past year the Vanguard Total Stock Market ETF (VTI), which tracks the 3,500-plus-member CRSP Total Market Index; BlackRock’s iShares Russell 1000 (IWB), tracking the FTSE Russell 1000; and State Street Global Advisor’s SPDR S&P 500 (SPY), tracking the S&P 500, all had daily-return correlations with one another of more than 99 percent. This occurs because of a top-heavy market-cap weighting system that results in similar concentrations in the same stocks despite varying numbers of member companies.
These correlations persist over a longer time frame. Note the overlap of long-term performance of these three ETFs over the past ten years, which renders them nearly indistinguishable from one another (see Figure 5). One hundred dollars invested in the SPY, VTI and IWB ETFs in 2007 would have resulted in $237, $244 and $239, respectively, ten years later.
From this standpoint, ETF fee structures may play a larger role in differentiating some major index returns than the index structures themselves, which appear increasingly commoditized. The growing market share of the Big Three, combined with the significant overlap of their largest shareholdings, has led some researchers to examine the potential for market distortions. Researchers at the University of Michigan have noted anticompetitive pricing effects in both the airline and banking industries that are correlated with increases in common ownership concentration, among other factors.9,10
Growing ownership concentration is, in turn, exacerbated by increasing industry concentrations across the entire market, with mergers and acquisitions outpacing new IPOs every year. In a 2017 paper another team of researchers found that industry concentration, as measured by a modified Herfindahl-Hirschman Index, has increased significantly since the mid-1990s.11 This trend has corresponded with an increase in share buybacks at the expense of investment, which the authors deemed “short-termism.”
Pitfall 4: Corporate Governance Is Improving but Still Lackluster
Could index funds, which ostensibly represent long-term shareholder interests, use their burgeoning power to signal a longer-term governance approach to corporations? The Securities and Exchange Commission has finally provided guidance to passive funds on the subject of corporate activism (in response to ValueAct Capital’s $11 million settlement with the Justice Department of charges that it bought shares of two companies under a merger antitrust review without reporting the purchases). Passives are now explicitly permitted to engage corporations on issues such as executive pay and environmental, social and corporate governance (ESG) without risking the loss of their passive filing status.
Although BlackRock and Vanguard have made increases in engagement and the transparency of their proxy voting in recent years, their records indicate a strong preference for management proposals over those of shareholders. During the 12-month period ended June 2017, BlackRock and Vanguard voted in favor of management proposals in the U.S. 92 percent and 95 percent of the time, respectively, while casting their weight behind shareholder proposals just 12 percent and 19 percent of the time, according to the companies’ proxy filing reports.12,13 On ESG issues Vanguard supported only 1 percent of U.S. shareholder proposals and zero percent internationally.13
One possible reason for these results thus far is that index funds’ low-cost structure does not provide sufficient resources for the firms to properly vet and propose changes for each company in their extensive portfolios. Another is that corporate pension funds are a significant consumer of index funds, creating a potential conflict of interest. In March 2017, Pensions & Investments estimated that about 51 percent of the top 100 corporate defined contribution plans were passively managed, with total defined contribution assets topping $1 trillion.
The Future of Passive Investing
Several upcoming enhancements could help mitigate the various impacts of passive investing. They include:
Staggered index rebalancing. The CRSP index recently moved to a five-day index rebalancing schedule every quarter, and S&P is currently engaged in a client consultation to potentially follow suit. And although FTSE Russell has not yet considered a multiday rebalancing schedule, it recently shifted some index adjustments from annual to quarterly reviews. This could mitigate some of the market impact the annual reconstitution creates.
More-proactive governance. The Investor Stewardship Group’s new framework for corporate governance, which includes broad guidelines for corporate behavior as well as specific structural remedies (such as annual elections for directors), launched in January 2018. Signatories include the Big Three; this could begin to affect corporate governance for U.S. companies in the upcoming proxy season. If the pace of change proves too slow for investors, however, one could expect more governance-related criteria, such as the exclusion of companies with onerous poison-pill plans, to be added to index methodologies in the coming years.
Cheaper benchmarks. Vanguard signaled the shift away from brand-name benchmarks when it moved several of its U.S. funds from MSCI to the CRSP index in 2013. As top fund managers continue to cut costs while vying for market share, expensive index provider fees may be next on the chopping block. State Street recently switched several ETFs from FTSE Russell to its own in-house indexes; smaller player WisdomTree already self-indexes all of its passive funds.
Passive products with overlays. Passive products that avoid concentration risk and market impact with the Big Three products should continue to gain traction. These include alternative index products such as smart-beta and ESG-focused funds. Given the increased emphasis on fiduciary responsibility, fund managers may look to market these products harder than traditional passive products, whose fees are tighter and more scrutinized because there is less product differentiation.
Though an improving regulatory environment and a low-cost structure likely ensure the staying power of passive investing, challenges remain if it is to continue its upward growth trajectory. In particular, solving the burgeoning ownership-concentration issue as assets continue to rise will be key.
1. Inigo Fraser-Jenkins, Paul Gait, Alla Harmsworth, Mark Diver, Sarah McCarthy. “The Silent Road to Serfdom: Why Passive Investing Is Worse Than Marxism.” Alliance Bernstein (2016).
2. Alistair Jones. “The Hidden Risks of Going Passive.” Schroders (2014).
3. Rodney N. Sullivan and James X. Xiong. “How Index Trading Increases Market Vulnerability.” Financial Analysts Journal 68, no. 2 (2012).
4. Dennis DeBusschere, Brian Herlihy, Max Trunz. “Quantitative Research: S&P Correlation Continues to Fall.” Evercore ISI (2017).
5. Antti Petajisto. “The Index Premium and Its Hidden Cost for Index Funds.” Journal of Empirical Finance 18, no. 2 (2011): 271-88.
6. “Russell 2000 Reconstitution Effects Revisited.” FTSE Russell (2017).
7. Victor Lin. “It’s Closing Time.” Credit Suisse Trading Strategy (2017).
8. Martijn Cremers. “Active Share and the Three Pillars of Active Management: Skill, Conviction and Opportunity.” Financial Analysts Journal 73, no. 2 (2017): 61-79.
9. José Azar, Sahil Raina and Martin C. Schmalz. “Ultimate Ownership and Bank Competition.” (2016).
10. José Azar, Martin C. Schmalz and Isabel Tecu. “Anti-Competitive Effects of Common Ownership.” Journal of Finance (forthcoming).
11. German Gutierrez Gallardo and Thomas Philippon. “Declining Competition and Investment in the U.S.” NBER Working Paper No. w23583 (2017).
12. “Investment Stewardship Report: 2017 Voting and Engagement Report.” BlackRock (2017).
13. “Investment Stewardship 2017 Annual Report.” Vanguard Group (2017).
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