The age-old pursuit of investment solutions that meet client needs has set the stage for a two-decade rise in passive investing. As evidence, from 1998 through 2016, the portion of US equity fund assets linked to market cap indexes — ETFs as opposed to mutual funds — has grown significantly, from 12 percent to 46 percent, according to Morningstar. Over this period, passive assets have tended to increase their market share more during years when the broad market Russell 3000® Index return was lower than it had been the year prior, and tended to decrease market share in years when the Russell 3000 Index return was trending higher. The pattern is much stronger for ETF asset flows than for the growth of passive investing as a whole, indicating that the features of the vehicle itself (the ETF) played a significant role in this shift.
Unintended consequences
The move to passive investing has prompted some theories regarding unintended consequences. Price distortion and reduced oversight of corporate governance are the two most prominent issues cited. The latter concern seems reasonable on its face, as passive investors do not buy or sell shares based on the idiosyncratic characteristics of individual companies, nor on evaluations of company actions or projected changes in value.
Passive index-based fund providers, along with large institutional investors that maintain significant holdings in passive assets, point out that oversight obligations are the same for all fiduciary entities whether assets are passively or actively invested, and that passive investment constraints require governance and guidance that is focused on long-term positive performance rather than short-term spikes or drops that active managers can exploit.
This debate has spurred providers of large passive index-based funds to publish new governance guidelines and policies, and now regularly report on proxy voting. Meanwhile, index-based fund providers and large institutional investors formed a new coalition on governance in January 2017. Interestingly, new academic research has found that greater passive holding percentages of company stock are associated with increasing independence of directors, reduction and/or removal of anti-takeover defenses (“poison pills”), and movement away from multiple share classes where there is a differential of voting rights.
The other negative that’s been associated with passive investment’s growth involves price distortion. Long-held beliefs do lend it credence: The essence of an efficient market is said to be the buying and selling of stocks by rational active investors who use a flow of information to anticipate changes in the present value of those stocks.
On that basis, active investors are credited with producing a balanced marketplace in normal conditions. They likewise are said to contribute to overall economic health by steering capital toward companies that are forecasted to do well and away from those that aren’t.
While some of the commentary connecting passive investing with price distortion includes so-called doomsday scenarios, the challenge of supporting these viewpoints with solid proof is not easily met. Among other things, it calls for identifying the relationship between the growth of passive investing and the increasing dominance of systemic factors in stock pricing, at the expense of company-specific or idiosyncratic factors.
In a statistical model designed to do just that, a linear regression defining the market share of passive assets as the independent variable and US equity return dispersion as the dependent variable reveals a decline in dispersion associated with the increase of passive assets. However, only a small percent of the change in dispersion levels is explained by the growth of passive assets.
In general, research efforts going forward need to move beyond simple correlations between the growth of passive assets and other phenomena. Passive asset growth has taken place concurrent with many other dramatic changes in the investment world, all of which impact the market in terms of pricing, volatility, and trends. Among these are a revolution in technology, increasing access to information, the appearance of new investment structures and vehicles (ETFs and derivatives, for example), changes in active management investment strategies, and the proliferation of index products, most notably, smart beta indexes.
In this context, it’s clear that carefully designed research is needed to disentangle the impact of these changes on the market and the economy from the impact of the contemporaneous growth of passive market share.
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