In its latest white paper, Epoch Investments Partners explores the impact that passive investing has had on market efficiency, and what investors need to consider in such an environment. Damien McIntyre explains.
At the end of the 1990s, actively managed mutual funds in the US accounted for almost 90 per cent of US equity assets, with passive mutual funds making up almost all of the rest (exchange traded funds (ETFs) were in their infancy); by 2016 that percentage was down to 61 per cent, with passive mutual funds at 22 per cent and index ETFs at 16 per cent.
Academic studies are beginning to shed light on how passive ETFs are influencing markets. These studies suggest that:
- Valuations for individual stocks are influenced by inclusion in indices;
- The volume of “informationless” ETF trading is raising trading costs for individual stocks and making the pricing of stocks less efficient;
- As ETF ownership of a stock increases, it begins to move more in line with its sector and with the overall market, and less in line with its own earnings; and
- Rising correlations will degrade the benefits of diversification.
Several studies have concluded that ETF trading is in fact having a measurable impact on the way individual stocks are priced – specifically, the volume of ETF trading is raising trading costs for individual stocks and making the pricing of stocks less efficient.
The first study dates from 2012: “The Impact of Passive Investing on Corporate Valuations”1 by Eric Belasco, Michael Finke, and David Nanigian. The study examined whether the steady rise in the amount of money being indexed to the S&P 500 has had any impact on the valuation of stocks in the index relative to the valuation of stocks outside of the index.
Based on data spanning a 14-year period from 1993 to 2007, they concluded that flows into S&P 500 index funds created a spread of 1.8 per cent between the price/earnings ratios of index constituents and non-constituents. PEs rose by 0.9 per cent for the stocks in the index and fell by 0.9 per cent for those outside the index. Based on price/book ratios, the spread was 1.5 per cent.
A valuation differential like this should present an arbitrage opportunity: an investor could go long a basket of non-S&P 500 stocks and go short a basket of stocks that are included in the index. Over time, one might think that the valuation differential should unwind, since it is driven only by the impact of fund flows and not on any fundamental factors. But of course, to succeed in such a strategy you would need to see the wave of money flowing into index funds stop, or even go into reverse.
As the authors note: “...It appears that the preference shift towards index fund investing is reducing the informational [or pricing] efficiency of stock prices. Informed investors may recognise the oversupply of capital allocated to stocks in indices and then place arbitrage trades which counteract the effect. However, the speed of adjustment back to equilibrium valuations will be slow in the presence of inattentive investors…By their nature, index fund investors are inattentive to valuations and…arbitragers (and perhaps most importantly those who provide them with capital) are rather impatient...Until the preference shift abates, attempting to arbitrage the mispricing away may drown those informed traders swimming against the tide of passive investment”.
In the second study “How Index Trading Increases Market Vulnerability”,2 Rodney Sullivan and James Xiong looked at how the rising level of money invested in index products, and the high volume of trading that takes place in those products, has affected correlations across stocks, both in terms of price movement and trading volume. Their study covered the period from January 1979 through December 2010, and included all U.S. stocks with market capitalisations greater than $100 million.
Having first observed and measured the rising level of price and volume correlation between stocks, the authors then hypothesise that the rising level of indexed assets has played a role in driving these correlations higher. And in fact, the data supports their hypothesis, which is not very surprising.
What is more interesting is the implications of these results. One of the clichés of finance is that diversification is a “free lunch”; a benefit that you can obtain without giving up anything in return. When you diversify your portfolio across a variety of stocks, your return will simply be the weighted average of the returns of the individual stocks.
But the volatility of the portfolio will not be equal to the weighted average of the individual stocks’ volatilities – it will be lower, because the returns of the different stocks will be less than perfectly correlated. That is, there will be times when some of your stocks are rising, while others will be falling, and as a result their movements will partially offset each other, resulting in lower volatility for your portfolio than the simple weighted average volatility. At the extreme, consider a two stock portfolio where each starts out at 50 per cent of the portfolio. If one stock rises five per cent and the other falls five per cent, your portfolio will experience no change at all, even though both stocks moved five per cent.
For diversification to work well, though, there has to be some occasions when there is divergence in stock movements, with some stocks rising and some falling. If stocks start to move more in line with each other, rising and falling together more often, then the benefit of diversification is reduced.
Finally, we turn to a more recent study, “Is there a Dark Side to Exchange Traded Funds (ETFs)? An Information Perspective,”3 written by Doron Israeli, Charles M.C. Lee, and Suhas A. Sridharan. The authors were interested in how inclusion in an ETF affects a stock’s “informational efficiency”. Their hypothesis was that when a stock is included in an ETF, this reduces the number of shares that are available to be traded by “uninformed” traders (people who are trading without reference to any fundamental information about a company). Because the uninformed traders provide liquidity to investors who are trading on fundamental information, reducing the number of these traders should tend to raise transaction costs, and this in turn would reduce the incentive for investors to seek out that fundamental information in the first place.
In their analysis, the authors looked at how changes in the level of ETF ownership of a stock were related to changes in that stock’s trading costs and to changes in several measures of pricing efficiency. Measuring trading costs is relatively straightforward – you can look at bid/ask spreads, for example. But how do you measure pricing efficiency? The authors relied on two measures: 1) “stock return synchronicity,” and 2) “future earnings response coefficient”. The first measure captures how much a stock’s price is driven by movements in the broader market or in the stock’s sector, and the second captures how much of a stock’s price movement is driven by the company’s own earnings.
The study covered the years from 2000 to 2014, and looked at a very broad universe of thousands of US stocks. After crunching through the data, the authors found as the level of ETF ownership of a stock rose, trading costs rose, and the stock began to move more in line with its sector and with the overall market, and less in line with its own earnings. (This is consistent with the earlier findings of Sullivan and Xiong about rising correlations across stocks as more money moved into passive vehicles). In addition, fewer analysts covered the stock as ETF ownership rose.
These three studies should be viewed as just initial efforts to understand how ETFs are affecting the stock market; more research is needed before we can draw firm conclusions. Taken together, though, they paint a fascinating picture of how the rise of passive investing may be making the equity market less efficient, even as the percentage of assets invested passively in the US has not even reached 50 per cent.
If these studies are correct, there would be far reaching implications. At the broadest level, it would lead to questions about the ability of the stock market to serve as an effective allocator of capital in the economy. While the stock market itself does not provide the initial start-up capital to new companies, the valuation of publicly traded stocks is often used as a benchmark by the venture capital and private equity investors who do provide that capital. If stock prices became less efficient at reflecting fundamental company information, those early stage investors would have an inaccurate view of which companies deserve capital, and at what cost.
At the level of the stock market itself, the research findings suggest that we might be losing some of the heterogeneity within the market. Well-functioning markets are ones where participants bring a wide variety of outlooks, and decision-making processes, to bear. People need to have a variety of opinions about what individual companies are worth, and their opinions need to be independent of each other. It is the very fact that people disagree about what things are worth that causes them to trade with each other. But what happens when people stop disagreeing, either because they all have the same opinion, or perhaps because they are not even bothering to come up with an opinion about what something is worth? There is a risk that market prices will deviate from any reasonable measure of fair value, potentially by a wide margin.
The goal here has not been to criticise ETFs. ETFs can certainly play a useful role in investors’ portfolios, but like every innovation, ETFs have had their share of unintended consequences. The studies reviewed show that even though passively managed funds account for just over one-third of US equity assets, the high level of trading in those funds has had a negative impact on the pricing efficiency of the stock market: trading costs have risen, stocks are more correlated with each other than they used to be and valuation is now partly affected by whether a stock is in a widely traded index or not.
In response, we believe investors need to focus more than ever on fund managers that look to the free cash flow fundamentals that drive long-term value creation, and to invest over a long enough time horizon such that the distortions being introduced by passive trading play only a marginal role in the total holding period return.
Damien McIntyre is director and head of distribution with Grant Samuel Funds Management (GSFM), and the distributor of the Grant Samuel Epoch Global Equity Shareholder Yield Funds.
1. Eric Belasco, Michael Finke, and David Nanigian, “The Impact of Passive Investing on Corporate Valuation, Managerial Finance, Vol. 38, No. 11, November 2012 1067-1084.
2. Rodney Sullivan, James Xiong, “How Index Trading Increases Market Vulnerability,” Financial Analysts Journal, Volume 68, Number 2, March/April 2012.
3. Doron Israeli, Charles M.C. Lee, and Suhas A. Sridharan, “Is there a Dark Side to Exchange Traded Funds (ETFs)? An Information Perspective,” working paper, January 13, 2017, Review of Accounting Studies, Forthcoming.