As passive investing goes from strength to strength, raking in ever more assets from active managers, one key question keeps coming up: could passive investing - and exchange-traded funds (ETFs) in particular - contribute to or even cause the next big market crash?
The interest in the topic is understandable. Firstly, stock market crashes are often associated with financial innovation. For example, the 1929 crash was exacerbated by the popularity of the newfangled financial vehicle of investment trusts. And 2008, of course, was aided and abetted by the growing popularity of complicated derivatives. So as the poster financial innovation of the day, you can see why ETFs have fallen under the spotlight.
Secondly, ETFs and passive indexing are public enemy number one as far as a lot of active managers are concerned. That's not to say that active managers are wrong to raise concerns about passive investing - but equally, you can understand why their reasons for fretting over the impact of indexing might not be motivated entirely by concern for the ordinary investor.
So is there a case to answer? Could ETFs and passive funds be tied to the next crash in the same way that CDOs are irredeemably linked with 2008?
Before we get into this, to be very clear, I'm very keen on passive investing. It has been great news for ordinary investors - it has given us a cheap, transparent route into asset markets, in stark contrast to the bad old days in which many an 'active' fund manager would simply hug the market, but charge you for managing your money as if it were their own.
However, I'm not an unquestioning fan of passive investing. As someone with a naturally bearish disposition, I'm always on the look out for what could go wrong in markets and given passive's soaring popularity, you have to think that it might at the very least be involved in the next crash.
So what might point to trouble ahead?
Is passive investing distorting markets?
Typically, what happens in a financial bubble is that more money flows into an asset market than can be justified by the fundamentals. In other words, market efficiency goes out of the window amid rampant fear of missing out. Eventually markets are so over-valued that it doesn't take much to rattle confidence. Even a minor disappointment can cause things to go pear-shaped. Portfolios are crushed in the ensuing stampede of selling.
So if you're trying to make the case that passive investing is likely to be somewhere near the heart of the next big bust, then I think you have to prove that it is distorting markets in some way.
And a couple of interesting recent pieces of research suggest that it might just be. Firstly, Vincent Deluard, global macro strategist at INTL FCStone started by looking at the explosion in the number of indices in the US, which is driven by index providers building new indices for ETFs and other financial products to track.
Deluard took stocks in the Russell 3000 index, and split them up according to the number of indices they feature in. The average US stock, according to Deluard, features in 115 indices. He looked at stocks which are in more than 200 indices (i.e. they're popular with index providers) and compared them to those in fewer than 75 indices (i.e. they're not-so-popular). He found that the popular stocks are roughly 2.5 times as expensive (as measured buy the price/book ratio) as the unpopular ones.
Now correlation doesn't equal causation. In other words, you can't say for sure that featuring in a lot of indices is what makes these stocks expensive (it might be that indices tend to favour expensive stocks). But you can see why you might want to jump to the former conclusion.
Deluard's argument is that if passive funds are distorting the market, then eventually the stocks that are over-represented in various indices will become so overvalued that they no longer outperform. As a result, active managers will be able to take advantage of this - although only in the long run - by buying the less popular stocks, which should eventually play catch-up.
What's particularly interesting is that there's a hint that this might be happening. Deluard notes that in the five years up to 2017, stocks that were held by the most indices also made the best returns. Yet during the course of 2017, the least popular stocks started to outperform.
Deluard isn't the only one to find an 'index' effect of sorts. Bloomberg notes that a team of Goldman Sachs strategists, directed by Arjun Menon and David Kostin, found that some stocks are effectively being overweighted by passive strategies as a collective whole.
What does that mean? The team looked at the Russell 3000. They then took the universe of passive funds and built an index according to their overall ownership by passive funds. In other words, they created a composite passive index and compared it to the Russell 3000. You might think that the collective passive universe would reflect the underlying index that it's meant to track. However, what the Goldman Sachs team found was that a small percentage of the stocks - just over one in 20 - had passive weightings that were significantly different to the underlying index. Some were more heavily owned than they 'should' be, while others were being underweighted.
The Goldman Sachs team argues that active funds can benefit from this distortion by owning more of the systematically overweighted stocks. After all, if passive funds are set to continue to attract money from investors, and this money is skewed to flow into some stocks in relatively larger proportions than in the underlying index, then you can beat the index by getting there before the wall of cash does.
For example, Berkshire Hathaway, Warren Buffett's investment vehicle, is more heavily owned than it should be. So is Facebook. Whereas, according to Goldman Sachs at least, Apple and Amazon are both under-owned. "Active managers could improve returns by increasing exposure to strategies that are the biggest beneficiaries of passive inflows."
So does this mean ETFs will be at the heart of the next crash?
Both of these studies suggest that we are starting to see inefficiencies creep in as a result of the popularity of passive investing. Does that mean that passive investing and ETFs will be to blame for the next crash?
I'm not sure that I'd go that far. However, I think it's reasonable to come to three main conclusions. Firstly, if there are structural distortions - and I can well imagine that there might be - then the US, where passive investing is most popular, is where we'll likely see them manifest earlier than in other markets.
Secondly, if there's a rush for the exits, then this suggests that it's the stocks that are most widely held by indices that you need to be wary of. Making use of this information isn't necessarily easy, but it'd be interesting to see if any active managers start to use this in their stock selection criteria. (Although frankly, I wouldn't be surprised to see the arrival of an ETF that is composed of stocks that are under owned by other ETFs before that happens).
Finally, whatever role is played by passive funds in the next crash, they are now too large a part of the investment landscape to escape all blame. Don't be surprised to see them take a lot of the flack, regardless of the underlying cause. They're simply too convenient a scapegoat.