Passive shift throwing financial system off-balance, finds Fed

Passive shift throwing financial system off-balance, finds Fed

Passive shift throwing financial system off-balance, finds Fed

Last month, the U.K.’s Financial Conduct Authority released a report concluding that growth in the ETF space does not pose a threat to financial-market stability. Several weeks later, Michael Burry, famously depicted in the 2015 film “The Big Short,” provided fuel for detractors of index investing by calling a “bubble” in the burgeoning space.

Now researchers from the Federal Reserve have weighed in on what the shift from active to passive investment strategies means, though those hoping for a tie-breaking take will be disappointed.

“[T]he ongoing nature of the shift suggests that its effects will continue to ripple through the financial system for years to come,” said the authors of The Shift from Active to Passive Investing: Potential Risks to Financial Stability?

The torrent of investment in passive products has profoundly affected the composition of risk in financial markets, they found, by magnifying some risks while softening others. They expressed particular concern over how it will impact financial stability, or “the ability of the financial system to consistently supply the financial intermediation needed to keep the real economy on its growth trajectory.”

One heightened area of concern is how ETFs could stoke market volatility, particularly as portfolio managers of certain passive strategies like leveraged and inverse ETFs are obligated to move according to the direction of the market “even in the absence of investor flows.” They cited evidence suggesting that leveraged ETFs probably contributed to stock-market volatility during the financial crisis, though they acknowledged that such products represent “a very small share of aggregate passive fund AUM.”

The researchers also noted the destabilizing potential from the increase in concentration within the asset management industry. A significant share of passive fund AUM and overall market shares have flown into the hands of several asset managers; one may consider how Vanguard has grown from representing 10% of all mutual funds and ETFs in December 1999 to accounting for nearly a quarter of the entire market by the end of last year.

Read also: Vanguard bullish after 'disrupting' active space

“[A] significant idiosyncratic event at a very large firm could lead to sudden massive redemptions from that firm’s fund and thus potentially from the asset management industry as a whole,” the researchers said. “As such, the continued growth of very large asset management firms raises concerns about the repercussions of serious problems at those firms for financial stability.”

On the bright side, the Fed researchers noted how the passive shift has blunted risks around liquidity and redemptions. The growing popularity of ETFs has enabled investors to forgo cash redemptions in favour of “in-kind” transactions, exchanging shares of a fund for “baskets” of securities that compose the underlying portfolio.

They also noted that passive-fund growth may be enhancing index-inclusion effects, including increased correlations in returns and liquidity among stocks that get included in indexes. However, they conceded that the evidence for such co-movement being linked to passives’ growing popularity is mixed.

“If index-inclusion effects (particularly price distortions) do become more significant over time, they may slow the shift to passive investing by increasing the profitability of active investing strategies that exploit these distortions,” the researchers said.

 

Follow WP on Facebook, LinkedIn and Twitter