Passive funds’ effect on stocks

This was written by Bloomberg Intelligence analyst Eric Balchunas. It first appeared on the Bloomberg Terminal.

The billions of dollars flowing into passive funds may slightly amplify the stock prices set by active traders, but there’s little evidence they dictate them or present a broader systemic risk. Despite concerns aired by hedge fund managers and other competitors, the more immediate threat is to asset management industry fees.

Burry’s passive concerns echo Signer, Iahn

Michael Burry is the latest high-profile hedge fund manager to express concerns over passive funds, joining a list that includes Paul Singer, Carl Icahn and Bill Ackman. Though index funds and ETFs are 1940 Act registered mutual funds, approved by the SEC and physically storing their holdings with a custodian, Burry compared them to the collateralized debt obligations that took down the market in 2008. Criticisms of ETFs and index funds over the years have typically centered on potential liquidity mismatches or distortion of asset prices, yet all types of investors – even hedge funds – continue to use them.

Not all hedge fund managers agree with the critics. Cliff Asness of AQR, for example, has denounced fearmongering about index funds.

High-profile hedge funds worry about passive

Minority ownership of market only amplifies

Passive funds’ influence in the market is growing, but their 18% ownership of U.S. stocks makes them a mild amplifier rather the driver of prices. Active investors – mutual funds, hedge funds, institutions and households – still account for the vast majority of stock ownership, and they react to news, fundamentals and Federal Reserve policy. The prices they set lift or shrink a stock’s market cap, prompting passive funds to adjust their weightings based on the change. This relationship is demonstrated anytime breaking news moves a stock quickly.

Passive funds may own more than 20% of a few pockets of the market – mostly temporarily hot areas with midand small-cap stocks, such as REITs and gold miners.

U.S. stock market cap vs. passive funds

GE case study: Passive ETFs in the passenger seat

ETFs and other passive funds lack the firepower to move stock prices significantly or to stop declines. During General Electric’s 2018 meltdown, for example, 147 U.S. ETFs held the shares. Despite the ETFs’ $46.3 billion of combined inflows – about double if index mutual funds are included – the stock plunged. The passive flows might have temporarily buffered the slide. Yet as time went on and GE’s market cap shrank, index funds had to adjust their weightings, which likely mildly amplified the downward momentum dictated by active traders. This is why stocks that are least-owned by passive funds can carry unique risks: because they’re the ones rejected by active managers.

GE price vs. cumulative flows of ETFs Holding GE

Closet indexing replaced by actual indexing

Unlike CDOs, the rush into passive funds isn’t centered on one small area of the market. Rather, it represents a change in the format for owning the same broad asset classes – albeit at much lower cost. If passive didn’t exist and the $5 trillion had instead gone into active mutual funds, those investors would own more or less the same stocks. Not only do active funds have a legal mandate to buy such shares, they tend to invest similar to their benchmark to avoid lagging too much behind it. Moreover, a big chunk of flows into passive equity come from active equity, essentially leaving ownership unchanged.

An investor who sold the Vanguard 500 Index Fund (SPY) and bought the actively managed Fidelity Magellan Fund (FMAGX) would have mostly owned the same stocks and gotten a similar return, while paying more than 5x the fee.

Fidelity Magellan’s SPX-ish top holdings

Biggest threat is to financial industry

Much of the criticism of passive investing is coming from people whose livelihood could be threatened by their growth, which may force the asset-management industry to shrink as fee revenue dwindles. Index mutual funds produce only $4 billion a year from an average fee of 0.1% and annual turnover of just 3%. ETFs are a little better – generating about $7 billion in revenue for asset managers and about $3 billion more for market makers, thanks to ETFs’ heavy trading volume. But neither is close to active mutual funds, which yield about $120 billion a year of revenue on about $12.5 trillion in assets and about 31% fund turnover.

Hedge funds such as Burry’s earn about $45 billion in fee revenue each year on only $3.1 trillion in assets.

Estimated annual revenue by investment vehicle

Wall Street has worried for almost 45 years

Criticisms and concerns about passive investing date back to the launch of the first index fund. In a 1975 letter to the Wall Street Journal, the director of research for the former Chase Investment Management warned that index funds would create market distortions. Vanguard’s first index fund was derided as “un-American.” Yet investors have voted with their feet as the spread of information has highlighted the importance of cost and the difficulty of beating the market. A continued favorable experience for investors may keep passive funds immune from mounting attacks.

“A proliferation of index funds, though accounting for ever-increasing amounts of investment monies, would lead to an inefficient market. A stock’s price would become more a function of the monies flowing into index funds than a reflection of its investment merits. The efficient market hypothesis would be dead.” – Mary Onie Holland, Director of Research, Chase Investors Management Corporation in the Wall Street Journal, Letters to the Editor, Dec. 8, 1975

Trading record in crisis counters concerns

The track record of passive funds in past crises has been stellar, with few disruptions to trading. Index mutual funds have proven highly sticky, with investors refusing to sell out of them no matter what’s happening. Some ETFs, on the other hand, experience sharp outflows and increased volume during more volatile periods. In the past 15 years, ETFs have traded about $200 trillion worth of shares. The estimated average size was $22,000, which breaks down to about 9 billion transactions. Known trading issues have been rare and isolated: In the first hour of trading on Aug. 24, for example, halts led to discounts and an estimated 3% of shares exchanged that day sold below net asset value.

Methodology: Trading volume figures are from the New York Stock Exchange, while the average trade size is from a survey of ETF market makers.

Total ETF trades vs. known trading issues

‘Blowup’ risk doesn’t deter hedge funds

Hedge funds may have concerns about passive funds, but that hasn’t stopped them from using ETFs. They’re long or short on about $170 billion of ETFs, including junk-bond products, which some hedge funds claim have a liquidity mismatch. At least 44 hedge funds, including Bridgewater and Point72, collectively have more than $900 million invested in the iShares iBoxx High Yield Corporate Bond ETF (HYG), with many increasing exposure. That’s despite Carl Icahn’s warning that the ETF could “blow up” due to a lack of liquidity in the bonds, which trade over the counter. While HYG’s $1 billion in daily volume accounts for 15% of total junk-debt trading, its $16 billion in assets makes up less than 2% of the $1.3 trillion debt market.

Many hedge funds increasing HYG exposure