Passive investing is growing, but it has consequences

The rise of passive investing and index hugging funds could be a bubble waiting to pop, but it presents an opportunity for good stock pickers.

The backdrop:
Index hugging and passive investing has been growing rapidly. In 2000, ETFs made up 2% of US trading volumes, but today passive index trackers control 45% of all assets in US stock based funds. 

On top of this, many pension funds are looking for higher yield in equities and alternative investments, largely because fixed income yields are at a historic low, and many sovereign wealth funds have followed suit, being heavily invested into equities.

What this means:
Due to the sheer volume of money in these index funds and passive investments, when they sell during risk off, the majority of stocks become oversold and fall, and when they buy during risk on, the majority of stocks are overbought. It has even made way for a strategy traders can exploit, proven in a study by the CFA institute:

“As the prices of individual stocks get dragged up or down with ETFs, these mispricings can become significant, and the profits realized by taking advantage of them”.

As more ETFs buy up markets and sectors without paying attention to the relative merits of the individual stock fundamentals held within, it creates opportunities for stock pickers when ETF constituents are rapidly oversold: “effectively handing returns on less correlated constituents to stock pickers.” the study said.

However, this means that the price discovery function for the constituents of an index fund is impaired, and the individual security due diligence done on each constituent limited. Michael Burry, the investor famous for shorting CDOs before the 2008 Great Recession, in an interview with Bloomberg asserts: 

“This is very much like the bubble in synthetic asset-backed CDOs before the Great Financial Crisis in that price-setting in that market was not done by fundamental security-level analysis, but by massive capital flows based on Nobel-approved models of risk that proved to be untrue.”

What the risk is:
Because of the sheer scale of the passive investors in equities, during a sell off with more sellers than buyers, prices will be forced down artificially in risk off periods. When prices are forced down other funds may start to sell, potentially leading to stock liquidity issues, creating further price reductions and mandated sell offs. The events of the Woodford Equity Income Fund in the UK highlighted similar concerns when a fund needs to sell securities that aren’t necessarily liquid.

To make things worse, Baby Boomers are retiring more now than ever. In the U.S. alone, almost 10,000 baby boomers turn 65 every day, and in 2031, there will be 75 million people over the age of 65. This is almost double what it was in 2008. When they retire, they will need to sell their holdings to generate cash or to convert to fixed income investments, putting even more downward selling pressure on equities. The end result is anyone passively invested in stocks, including pension fund holders and passive fund holders, could be in for a lot of pain when the penny drops. 

What the opportunity is for investors:
However, this may be the time that individual due diligence on securities, and concentrated portfolios of high quality companies can outperform. If you look at the constituents of an index, there are some clear winners and losers. But an index hugging fund holds both. It will be the stock pickers, with greater insight into fundamental valuations, who can avoid the losers and flourish. As the Financial Times asserted in an article last year:

“The times are improvement for investors looking for diamonds (or rubbish) in the rough”