‘Free-riding’ passive investors under central bank scrutiny

Passive investors pay scant regard to the fundamentals of individual securities and free-ride on the work of active investors with implications for financial stability, price discovery and index correlation, according to a paper from the Bank of International Settlements.

'Free-riding' passive investors under central bank scrutiny

The implications of passive investing for securities markets cuttingly referred to passive investors holding “scant interest in the idiosyncratic attributes of individual securities in an index”.

“In effect, they free-ride on the efforts of active investors in this regard,” said the authors, Bank of International Settlements (BIS) economists Vladyslav Sushko and Grant Turner.

The growth of passives could therefore reduce the amount of information embedded in prices and contribute to pricing inefficiency and the misallocation of capital, they argued.

The publication in the central banking organisation’s quarterly review, published on Sunday, comes as the Central Bank of Ireland (CBI) sharpens its focus on the ETF industry, currently taking on board feedback from the industry to a policy discussion paper it released last May.

The BIS paper concluded three issues connected to growth in lower-cost passive portfolio management were worthy of further investigation: the impact of passives on price discovery and correlations between index constituents; the relative stabilising influence of index mutual funds compared to ETFs and active funds during periods of market stress; and the effects of active funds versus ETFs on underlying security prices.

High growth from a low base

Lyxor head of ETF strategy for Northern Europe Adam Laird said passive investors could be argued to be free-riding on active investors’ hard work, but this needed to be seen in the context of their size.

“Passive funds invest on the price in the market. The prices are set and influenced by everyone and by implication active investors and individual stock pickers have a big role in setting that. Overall passive investment is still a very small part of the market,” he said.

Laird said he took comfort from the fact the paper acknowledged that passives still represent a small part of financial markets.

“Investors often see the rapid growth in ETFs, but perhaps haven’t realised that overall it’s a minor part of financial markets. It’s high growth from a low base.”

Index funds versus ETFs

In comparison to ETFs and active funds, index fund inflows were the least volatile during the 2013 taper tantrum, 2015 stock market turbulence and 2016 US presidential election, both in relative and absolute terms compared to ETFs and active funds, the BIS paper found.

Active funds suffered the most persistent outflows over the three market-stress periods, which the authors attributed to investors worrying about fund performance, a factor that does not come into play for ETFs and index funds simply trying to track a benchmark.

The higher flows volatility for ETFs over index funds was attributed to intraday trading in the former, in contrast to trading at the close of the day typical of index funds.

“The ability to trade ETFs frequently could attract high-turnover investors and investors pursuing shorter-term investment strategies, such as high-frequency trading (HFT) or dynamic market hedging,” the authors said.

Authorised participants

There is a more direct relationship between active fund inflows and the trading of underlying securities than in ETFs, which Laird said he was pleased to see recognised in the BIS paper.

“When you buy into an active fund the manager needs to go out and buy all the shares immediately. When you trade an ETF it’s bought or sold by an authorised participant and they can take a couple of days to actually process the trading,” Laird said.

Keep an eye on correlation

Correlation is an area for investors to keep an eye on as passives’ market share grows because it could mean index constituent prices move down in tandem during periods of market volatility.

Laird said behavioural solutions rather than asset allocation is the best way for investors to navigate a more correlated market.

“There is always a potential that if you hold an investment and you need to sell in a panic you’re not going to get the best price. If rapid growth in passives continues there is more potential for this,” Laird said.

Despite some of the concerns raised, Laird said he took some comfort from the paper.

“ETFs and their growth is a question mark for regulators at the moment; it’s something they’ll continue to look at. It wouldn’t surprise me if there’s more regulation to come.”

Laird was last month appointed the first chairman of the Investment Association ETF committee, which has put a lot of its energy over the last year into feedback for the CBI’s discussion paper on ETF regulation.

It warned against over regulation of ETFs compared to traditional fund structures, saying while ETFs faced additional risk factors, existing regulation, such as Esma’s Guidelines on ETFs and Other Ucits Issues, already addressed that.

But Laird added: “While the BIS paper has brought up questions, I don’t feel there’s anything in there that is clearly going to be the next regulatory issue.”

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