If this is capitalism, where are the price signals?: The glacial effects of passive investment

Eelke Heemskerk - Associate Professor of Political Science, University of Amsterdam

Adam Leaver - Professor in Accounting and Society, co-director of SPERI

But arguably the shift from active to passive investment strategies may be doing something similar in equities markets. Passive investment funds embody the logic of the efficient market hypothesis – that because share prices incorporate all available market information, no single investor can ever outperform the market over the long term. Passive investment funds therefore do not trade individual stocks on the basis of their fundamentals, but rather assume that the market is ‘right’ and so only buy or sell a stock when the composition of an index like the S&P500 changes. By stripping out the costs of fundamentals analysis and active trading, passive index funds compete on price, offering a low-cost, low-fee model to investors.

The growth of passive investment is quite astonishing. Between 2007 and 2016, actively managed funds in the US recorded outflows of roughly US$1,200 billion, while index funds received inflows of over US$1,400 billion. By 2017 the Big Three passive asset managers – BlackRock, Vanguard, and State Street  –  held nearly $11trillion assets under management – three times the value of the global hedge fund industry. In 88% of S&P500 firms, the Big Three seen together as one investor block are the largest shareholder (see Figure 2). It is estimated that only about 10 per cent of US equity investment is now done by active, fundamentals-based traders.

But the growth of passive investment raises philosophical questions about what information is ‘in the price’ and what drives it? What happens when passive funds become so large that they are the market, or at least are able to affect market pricing significantly? A recent FT article by John Plender explains that the results can be self-fulfilling or circular.

‘In indices weighted according to market value, net inflows into passive portfolios result in the share of overvalued stocks in the index increasing in a rising market …Inter alia, the growth of passive investing must lead to greater correlation of indexed securities and a reduction in company-specific information contained in stock prices.‘

If stock prices of firms that are constituents of an index correlate to that index rather than underlying firm performance, then the price mechanism is not functioning fully. Ironically it may be the case that passive investors require strong active investors in the market for their investment strategies to work; to avoid their investments becoming self-fulfilling.

This is worrying because it implies that in debt markets and equity markets prices are being shaped by monolithic forces that are softening the kind of information that capitalists might be expected to trade on. If this is capitalism, it is a very strange form where the traditional role of markets and prices as part of a dynamic, self-adjusting system have given way to the slow, unyielding momentum of two glaciers which now carve their impressions into the economic landscape.

There are two risks posed by the latter of these glaciers. A recent Bank of England working paper assessed the impact of passive investment strategies on bond markets. They found that in the short term those strategies temper endogenous volatility, particularly the tendency for momentum or value investors to over- or under-shoot in response to news-flow (in much the way described above). However, over the medium to long term they argue that passive strategies significantly increase the tail risk of large yield dislocations when exposed to more serious exogenous shocks.

We can quibble about whether ruptures of this sort are endogenous or exogenous, but if we transpose this argument about bonds to equities – it suggests that when passive strategies become dominant forces within markets, they may create the conditions of their own success, because passive funds have the capacity to both benefit from and constitute a low-volatility upswing. However, this comes at the risk of bubble-formation and a messy unravelling at times of crisis if funds try to exit increasingly illiquid positions in tandem, leading to the kind of distressed selling we have seen in other crises.

But this raises a second problem: does the presence of passive investors cause management to act in ways that increases the risk of an unravelling? Managers may be more insulated from volatile stock price movements, but passive investment funds are far from passive when it comes to the exercise of their voting rights. Funds like BlackRock invest passively but vote actively, often with management who through stock option based bonuses are now incentivised to deliver short-term shareholder value. According to a series of economic studies, these ‘passive-aggressive’ tendencies lead to higher dividend payments, an increase in CEO power through the appointment of fewer independent non-executive directors and lower capital expenditure. This strange post-crisis world of more voice but less exit pressure from capital markets may explain why managers have chosen to extend their empires through increasingly expensive inorganic expansion (it’s easier to pay a larger lump of dividends when combining two businesses) and seem keener to embrace the accounting innovations which allow the time-shifting of income and costs. But this is only storing up future problems; the combination of pricing softness on the liability side and the speculative character of goodwill (and other accounting items) on the asset side may well bring about the more volatile economic conditions which passive investment strategies have always struggled to adjust to.