Passive investing accused of inflating the stock market bubble

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The trillions of dollars that have poured into passive funds in recent years have inflated valuations, radically reshaping the U.S. stock market and shielding it from the threat of a sustained bear market, research shows.

Vincent Deluard, global macro strategist at broker StoneX, argued that the unprecedented flows led to structurally higher stock valuations, disconnected from corporate fundamentals, benefited large stocks and growth stocks at the expense of high-end stocks. value and small cap and resulted in decrease and shorter life. , market corrections.

“A preponderance of evidence suggests that the rise in liabilities played a major role in the stock market bubble of the past decade,” said Deluard. “If the rise in liabilities is the main cause of this bull market, a sustained bear market can only occur if the passive sector contracts.”

At the end of July, $ 7.3 billion was held in passive open-end and exchange-traded funds that invest primarily in U.S. stocks, according to Morningstar, exceeding $ 6.6 billion in open-end funds. comparable actively managed, although the overall share of liabilities is lower when direct investment and external funds are taken into account. Index investments have also grown rapidly in some European countries.

Deluard argued that this shift from active “price sensitive” investors to passive “independent value” investors played a role in the rise in stock valuations.

Its data shows that the cyclically adjusted Shiller price / earnings ratio of the S&P 500 index “had no discernible trend” between 1881 and 1993, when the SPDR S&P 500 ETF (SPY), the first US ETF, was launched, with an average of 15.4 over this period. .

However, Shiller’s m / e has risen sharply since 2003, and is now a record 38 times.

Chart: Will the trend ever stop?

Deluard does not attribute all of this boom to the growth of passive funds. The collapse in interest rates and colossal asset purchases by central banks seen since the global financial crisis “have likely played a larger role” in the rise in stock market multiples, he said.

Nonetheless, Deluard estimated that the rise in independent passive funds in value accounted for 27% of the increase in the cyclically-adjusted Shiller ratio.

He believed that this pattern was held internationally as well, with a positive correlation between passive share in a given market and valuations, at least when expressed as the price-to-sales ratio.

What’s more, his data suggests that market corrections have become rarer and price declines less deep, which he attributed to passive investing creating “a stable buyer who can step in when investor sentiment deteriorates.”

Line graph of the ratio of small cap stocks / value returns to the broad U.S. stock market (rebased) showing small cap and value stocks are losing their mojo

Digging deeper, value and cheap small-cap stocks have underperformed in the US since 2006, a reversal of the performance premiums that these two style factors have traditionally provided.

While other factors such as falling interest rates, which benefit growth stocks, could be responsible, Deluard argued that this trend could also be due to “continuous exits from the active sector, which tends to overweight »value and small caps.

Within the size component, he found that buying the two largest stocks in the Russell 3000 Index at the end of each year had returned 411% since 2014, compared to 143% for the index as a whole, a reversal of the “winner’s curse”. that was once prevalent, again potentially due, in part, to net purchases of large-cap stocks as investors shift from active to passive funds.

Line graph of the performance of the two largest Russell 3,000 stocks against the larger (rebased) index showing the run of the largest US stocks

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

However, he added that “on the volatility front, I compare this to forest fire management” – where policies to put out every small fire lead to a build-up of combustible undergrowth that can lead to more conflagrations. important and more devastating.

One potential criticism of his analysis is that, even without the advent of passive investing, the wall of money that has entered the stock markets over the past few decades likely still would have done so through actively managed funds, this which means valuations in general could be just as high.

Deluard acknowledged that this was a “logical argument”, but felt that active fund managers “would try to deploy their cash more strategically. If you have higher entries you don’t have to buy high, you can buy dips. Passive will buy right away.

“Almost $ 1 billion has been invested in ETFs over the past year. If you move that much money so quickly, it will have an impact on the price, ”he concluded.

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

“By definition, they don’t participate in price discovery. They are price takers. It certainly has consequences, ”he said. “There are fewer market participants correcting pricing errors. This can lead to longer bubbles and increase the risk of contrarian strategies. “

Kalesnik also attributed the changes in the nature of the markets to an increase in retailer participation, which “has likely doubled over the past 15 years”, meaning more “fashion-inclined, over-reacting investors”. news and gregarious behavior “. . . increasing the risk of poor pricing.

However, Ben Johnson, director of global ETF and passive strategy research at Morningstar, argued that index fund trading activity “represents a small minority of global trading volumes, so every day the hard work of Price discovery is always done by market participants with different opinions about the securities’ intrinsic value.

“I think we’re still a long way from any sort of tail-wags-dog type scenario where index funds undermine the pricing process,” Johnson added.

“And if we get to that point, the market will eventually heal itself. New opportunities will present themselves for active market participants and the pendulum will start to swing the other way. “

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