Passive market bubble fears overblown, index maker argues

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The jury is out on whether the passive investment boom distorts market fundamentals, a recent paper by index provider FTSE Russell argues, with further evidence required to settle the case.

In its report titled ‘The growth of passive investing: Has there been an impact on the US equity market?’,  FTSE Russell debunks some concerns that the secular shift to index-style management has lowered corporate governance standards as well as severing the link between security pricing and economic fundamentals.

For example, the study says large index managers are increasingly taking the lead on corporate governance while the effect of growing passive market share on ‘price discovery’ remains a grey area.

“There is a persuasive logic to the argument that increasing allocation to passive rather than to active investment products has the potential to impact the validity of prices. Specific evidence for pricing distortions caused by passive investing is to date thin on the ground, however,” the report says.

Previous research looking at the influence on stock prices of their inclusion or exit from indices has found just weak evidence of passive distortions, the paper says.

Meanwhile, a “quick analysis” by FTSE Russell shows a negative correlation between an increase in passive assets and dispersion (essentially the degree to which stock prices are affected by systemic factors rather than individual company fundamentals) in US shares over the 18 years to December 31, 2016.

But a further statistical measure indicates that over the 18-year period “only a small percent of the variation in dispersion levels is explained by the growth of passive assets”.

“We do not claim that this quick analysis is the last word on this question, but it is an indication that there are other, yet-to-be-determined, factors driving the behavior in dispersion over this period,” the FTSE Russell report says. “This opens the door to a discussion of other factors that may have impacted market pricing behavior above and beyond the increases in passive investing.”

The report suggests technological change, increasing ease of access to market information once restricted to privileged players, and the rise of derivative-based investment structures could all be more influential on changing investment dynamics than growth in passive funds per se.

“New, carefully designed, research is needed to disentangle what impact these changes have had on the market, prices, and the economy from the impact of the contemporaneous growth of passive market share,” FTSE Russell says.

The issues are no longer academic, however, with passive market share (in US equities, at least) increasing exponentially over this century, according the FTSE Russell, which defined the sector solely as market-cap weighted vehicles – including managed funds and exchange-traded funds (ETFs) but excluding ‘smart beta’ products and ‘index hugging’ active managers.

“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,” the report says. “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.”

While the US has to date provided the most fertile data on index investing trends, the FTSE Russell study says research on the “Japanese equity market, where passive market share is now reported at 70%, may offer insights”.

Owned by the London Stock Exchange, FTSE Russell is probably the largest of the big three index providers (along with S&P Dow Jones and MSCI), with about US$15 trillion of active and passive investments tracking its benchmarks, according to The Economist. S&P boasts about US$12 trillion (with US$4.2 trillion linked to passive funds) while MSCI reports fund followers valued at US$11 trillion, the August 2017 article says.

– David Chaplin, Investment News NZ

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