Mon. Dec 6th, 2021


The trillions of dollars that have fallen into passive funds over the past year have inflated valuations, radically reformed the U.S. stock market and isolated it against the threat of a sustained bear market, research has claimed.

Vincent Deluard, global macro strategist at brokerage StoneX, argued that the unprecedented flow led to structurally higher valuations of the shares decoupled from the fundamentals of the business, favoring large and growing stocks at the expense of value and small-cap stocks and led to less and shorter lifespan. , market corrections.

“A large body of evidence suggests that the rise of passive has played an important role in the stock market bubble of the past decade,” Deluard said. ‘If the emergence of passive is the main cause for this bull market, a sustained bear market can only take place if the passive sector shrinks.

At the end of July, $ 7.3 tons were held in passive open and exchange traded funds that invest primarily in US equities, according to Morningstar, which outweighs the $ 6.6 tons in comparable actively managed funds, although passive’s total share is lower is when direct investment external funds are taken into account. Index-based investment has also grown rapidly in some European countries.

Deluard argued that this shift from ‘price-sensitive’ active investors to ‘value-agnostic’ passive investments played a role in boosting stock valuations.

Graph: a trendless century

Its data show that the cyclical adjusted Shiller price / earnings ratio of the S&P 500 index “had no noticeable trend” between 1881 and 1993, when the SPDR S&P 500 ETF (SPY), the first U.S. ETF, was launched, averaging 15.4 over this period.

However, the Shiller P / E benchmark has risen sharply since 2003 and now stands at a record high 38 times.

Graph: Will the trend ever end?

All this increase Deluard does not attribute to the growth of passive funds. The collapse in interest rates and huge purchases of the central bank’s evidence since the global financial crisis “probably played a bigger role” in raising stock multiples, he said.

Nevertheless, Deluard estimated that the increase in passive value agnostic funds accounts for 27 percent of the increase in the cyclically adjusted Shiller ratio.

He was of the opinion that this pattern is also held internationally, and there seems to be a positive relationship between passive share in a given market and valuations, at least when expressed by the price-to-sales ratio.

In addition, his data indicates that stock market corrections have become rarer and price declines have become smaller, which he attributed to passive investing, which ’causes a solid buyer to intervene when investors’ sentiment sours’.

Line chart of the ratio of returns from small / value stocks to the larger US stock market (rebuild) showing that small and value stocks lose their mojo

With further declines, cheap “value” and small-cap stocks have underperformed in the U.S. since 2006, a reversal in the yield premium that these two style factors have traditionally provided.

While other factors, such as declining interest rates, which may benefit growth stocks, may be responsible, Deluard argued that the pattern may also be due to ‘continued outflow from the active sector, which is prone to overweight’ value and small capitalization.

Within the size component, he found that the purchase of the two largest shares in the Russell 3,000 index at the end of each year yielded 411 percent since 2014, compared to 143 percent for the index as a whole, a reversal of ‘winner’s curse ‘that once prevailed, possibly again partly due to the net purchases of megacap shares as investors ranged from active to passive funds.

Line chart of returns of two largest stocks in the Russell 3,000 versus the broader index (rebuild) ahead of the largest U.S. stocks

Deluard is not an opponent of index tracking funds per se and accepts that the passive revolution has brought benefits, such as investors “wasting less money on mediocre, overpaid active managers and their large distribution structures”.

However, he added that “on the volatility front, I compare it to forest fire management” – where policies aimed at extinguishing every small fire lead to a build-up in combustible undergrowth that can lead to larger, more devastating burns.

One possible critique of his analysis is that, even without the onset of passive investment, the money wall that has entered stock markets in recent decades would probably still have done so via actively managed funds, meaning that valuations are generally just as high can be.

Deluard accepted that this was a ‘logical argument’, but believed that active fund managers’ would try to deploy their money more strategically. If you have higher inflows, you do not have to buy high, you can buy the dips. Passive will buy immediately.

‘Over the past year, nearly $ 1 billion has been invested in ETFs. If you move so much money so fast, it has an effect on the price, ‘he concluded.

Vitali Kalesnik, director of research in Europe at Research Affiliates, a pioneer in smart beta strategies such as value and small capitalization, agreed that the rise of passive investors had an ‘impact’ on markets.

‘By definition, they do not participate in price discovery. They are price takers. It definitely has consequences, “he said. ‘There are fewer market participants fixing for wrong prices. This can lead to longer bubbles and increase the risk of conflicting strategies. ”

Kalesnik also attributes the changes in the nature of markets to an increase in retail participation, which “probably doubled in the last 15 years”, meaning that more investors “tend to fad, overreact to news and herd behavior … increase the chance of wrong prices. ”

However, Ben Johnson, director of global ETFs and passive strategies research at Morningstar, argued that index funds ‘trading activities’ make up a small minority of global trading volumes, so on any given day the hard work of price discovery is still being done by market participants with diverse views on the intrinsic value of securities ”.

“I think we are still a long way from a kind of scenario with a tail watch dog, where index funds undermine the pricing process,” Johnson added.

‘And if we achieve that, the market will eventually heal itself. New opportunities will emerge for active market participants and the pendulum will begin to swing back in the other direction. ”

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