A recent article in the Globe and Mail forcefully made the case that the huge growth of passive investing is distorting markets and creating unintended risks for investors.
The article claims mutual funds and exchange traded funds that passively track indexes are increasingly crowding out actively managed funds and distorting the value of the markets they are designed to track.
It also claims that because they buy and sell baskets of stocks, index mutual funds and ETFs are increasing stock market correlation, thereby reducing the diversification benefits of passive investing and increasing volatility.
According to the article, the volatility is particularly evident in severe market downturns, such as the one we’ve just experienced, because passive funds “are forced to indiscriminately sell the underlying components of the index fund or ETF, irrespective of industry sector or fundamentals.”
This is just the latest chapter in a long-running debate over how much of an impact passive investing is having on the markets. Unfortunately, the Globe piece, like others of its ilk, makes several assertions that just don’t stand up to scrutiny.
The author correctly points out that passive investing relies on markets being efficient—ensuring share prices reflect all information available to the market. Active managers and analysts make markets efficient by constantly scrutinizing and trading stocks.
However, there is no shortage of people doing exactly that. From huge sovereign wealth, pension and endowment funds to active mutual fund managers, there are more than enough people studying stock prices to keep markets efficient.
According to PWL Capital research, just 12% of total assets held in Canadian mutual funds and ETFs are passively managed. In the U.S., the proportion is 39% and worldwide 27%.
Another indication that active investment management remains healthy is the number of chartered financial analysts being turned out each year. CFA Institute membership grew to 178,000 worldwide in fiscal 2019 from 135,000 five years earlier.
There is also no evidence to support the idea that passive investing is increasing market volatility as demonstrated in this PWL article. Indexing is most popular in the U.S., yet the volatility of the S&P 500 has stayed within a range of 10% to 20% since 1970.
Finally, the idea that ETFs are increasing correlation among stocks is also baseless. If this were the case, we would see a much narrower spread between the best performing and worst performing stocks in the market as the popularity of ETFs grow. Yet, the data do not show this. Instead, an analysis of cross-sectional dispersion of returns, a measure of the variability in stock returns, shows that stocks have not become more closely correlated with one another in recent years, despite the rise in ETFs.
We’ve seen the arguments in the Globe and Mail article before. They usually from come from investment managers who are losing market share and can no longer charge the exorbitant fees they once did. Unfortunately, the arguments lack rigour and evidence to back them up.