Is Passive Investing Distorting the Market?

Assets continue flowing into passive investing products, but some industry insiders worry that the popularity of index investing could be destabilizing the underlying stock market, Barron’s writes. 

Number of Indexes Rises as Number of Stocks Falls

The passive vs. active debate has been heating up recently as active managers underperform benchmarks while the indexes keep reaching new highs, the publication writes. It’s no wonder then that investors continue taking their money out of actively managed products and steering them toward passive products, according to the publication. Through May, passive mutual funds and exchange traded funds pulled in $338 billion, according to Morningstar, and at this pace the inflows for 2017 could be close to double what they were in in 2015, Barron’s writes. 

Meanwhile, the number of indexes has jumped from 1,000 a decade ago to 6,000 today, according to the publication. The number of stocks in the Wilshire 5000 Total Market Index, however, plunged from 7,562 in 1998 to 3,599 today, Barron’s writes. 

And this phenomenon could be distorting and destabilizing the market, particularly combined with the narrow trading volume in stocks, which remains 30% lower than it was in 2009, according to the publication. For one thing, by virtue of the product’s design, buyers of cap-weighted indexes invest in overweight stocks rather than underweight ones, Barron’s writes. What’s more, index fund investors stand to ride a bear market down all the way, as opposed to active managers who can diversify or go to the safety of cash, according to the publication. Meanwhile, stocks with the most shares held by passive funds are also significantly more volatile, Barron’s writes. 

It’s hard to determine the point when passive investing puts the markets in peril, according to the publication. Markets in Japan are doing just fine even though passive strategies account for 67% of the assets, Barron’s writes. That figure is still just 37% in the U.S., according to the publication. 

On the other hand, many people thought subprime mortgages couldn’t really affect the housing market, and certainly not the entire financial system, when they made up 23.5% of mortgage originations in 2006, Barron’s writes. And there could be parallels between the popularity of passive investing and the credit crisis, Aaron Brask, a former Barclays strategist now running his own investment management firm, tells the publication.

“When investors stopped conducting their own due diligence and started relying on rating agencies, it opened the door for capital misallocation, and ultimately culminated in the credit crisis,” he tells Barron’s.

There’s some indication that active managers are making a comeback, however. While $343 billion flowed out of active funds last year, this year, it’s slowed to a trickle, with just $6 billion leaving active funds thus far, according to the publication. Meanwhile, more than half of large-cap fund managers outperformed their benchmarks in June, Barron’s writes. That was the fourth month in a row, which is the longest winning streak they’ve had since 2009, according to BofA Merrill Lynch data cited by the publication.

Commentary on Barron’s article by Kopin Tan

Posted by: The Wealth Advisor


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