Swedroe: Index Investing’s Market Impact

Over the past few decades, there has been a substantial shift from active to passive investment strategies. The shift has occurred as investors have become more aware of the persistent failure of active management, as demonstrated in the S&P Dow Jones biannual Indices Versus Active (SPIVA) reports.

A January 2019 Federal Reserve Bank of Boston study, “The Shift from Active to Passive Investing: Potential Risks to Financial Stability?”, found that “Passive funds made up 45% of the assets under management (AUM) in equity funds and 26% for bond funds at the end of 2017, whereas both shares were less than five% in 2005.”

Wall Street has been attacking and ridiculing passive investing for decades. Among the arguments is that the rise of passive investing results in a reduction in price discovery efforts, leading to prices being distorted and capital allocated inefficiently.

An example of this type of criticism was an article titled “What They Don’t Tell You About Passive Investing.” Produced by Morgan Stanley, the thrust of the paper was that “The exodus from active to passive funds may be reaching bubble-like proportions, driven by an exaggerated critique of active management.”

The great irony is that if indexing’s popularity were distorting prices, active managers should be cheering, not ranting against its use, as it would provide them easy pickings, allowing them to outperform. (Note that if money flowing into passive funds distorts prices, it could still make it difficult for active managers while it is occurring, as distortions could persist as long as the flow continued. Eventually, though, the opportunity would manifest itself.) But in reality, the rise of indexing has coincided with a dramatic fall in the percentage of active managers outperforming on a risk-adjusted basis.

Falling Skill Levels

For example, the study “Conviction in Equity Investing” by Mike Sebastian and Sudhakar Attaluri, which appeared in the Summer 2014 issue of The Journal of Portfolio Management, found that the percentage of skilled managers was about 20% in 1993. By 2011, it had fallen to just 1.6%.

This closely matches the result of the 2010 paper “Luck versus Skill in the Cross-Section of Mutual Fund Returns.” The authors, Eugene Fama and Kenneth French, found that only managers in the 98th and 99^th percentiles showed evidence of statistically significant skill. On an after-tax basis, that 2% would be even lower.

An interesting new paper, “Passive Asset Management, Securities Lending and Asset Prices,” demonstrates that the rise of passive investing may even be contributing in some ways to increasing market efficiency. Darius Palia and Stanislav Sokolinski, authors of the February 2019 study, investigated the impact of the increase in passive investing on securities lending, which plays an important role in market efficiency—the cost of borrowing securities limits the ability of arbitrageurs to correct mispricings.

The cost of borrowing a stock to short it can be expensive. There also can be a limited supply of stocks available to borrow for the purpose of shorting (this can be especially true for small growth stocks). In addition, short-sellers run the risk that their borrowed securities are recalled before the strategy pays off. If passive investors increased the supply, the price of borrowing might fall, reducing the limits to arbitrage and allowing markets to be more efficient. The study covered the period 2007 through 2017.

Research Results

Following is a summary of their findings:

• Passive funds participate more aggressively in stock-lending programs than active funds and other nonmutual fund lenders—lending shares to arbitrageurs (such as hedge funds) who are seeking to short the stock.
• Stocks with a high level of passive ownership exhibit greater supply of lendable shares, which results in larger short positions, lower lending fees and longer durations of security loans. The effects are both statistically and economically meaningful. For example, a 1 standard deviation increase in passive ownership is associated with an increase in a half-standard deviation in lending supply. And moving from the 25^th percentile (1%) to the 75^th percentile (10%) of the passive ownership results in 27 basis points lower lending fees.
• The effect of passive investors on security lending is significantly larger than the effect of other lenders, such as actively managed funds and other institutional asset managers.
• By limiting short-sale constraints, stocks with more passive ownership exhibit lower cross-serial correlations with negative market returns and less negative skewness in stock returns— price discovery conditional on negative information is faster for constrained stocks when passive ownership is higher.

The bottom line is that the shift to passive investing has generated a significantly greater supply of lendable stock, resulting in larger aggregate short positions, lower lending fees and longer security loan durations. The result is that short-sale constraints that allow mispricings to persist are relaxed—stocks can be borrowed more easily, at lower prices, and for longer time periods. By their actions, passive investors are making the market more efficient. Palia and Sokolinski concluded: “By making short-selling possible, passive investors can complement the information acquisition efforts of active investors who are willing to short-sell stocks. As a consequence, markets can exhibit faster price discovery by incorporating negative information into stock prices.”

They add that their “results cast doubt on the idea that passive investing only reduces the amount of information incorporated in prices and generates price inefficiencies. In fact, the relaxation of short-sale constraints leads to more information being embedded in securities prices.”

Summary

As sure as the sun rises in the east, the proponents of active management will continue to attack passive investing. The reason is simple: It threatens their livelihood. Thus, their behavior should not come as a surprise.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.