Passive investing accused of inflating the stock market bubble

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Studies claim that the trillions of dollars that have flooded passive funds in recent years have inflated valuations, radically reshaping the U.S. stock market and insulating it from the lingering threat of the bear market.

Vincent Deluard, global macro strategist at brokerage firm StoneX, said unprecedented trends have led to structurally high valuations of stocks separated from company fundamentals, benefiting large growing stocks at the expense of value and small stocks. capitalization. Provoked, resulting in shorter lifespans and shorter lifetimes, demanding market changes.

“The predominance of evidence suggests that the rise in liabilities has played a major role in the stock market bubble over the past decade,” said Deluard. “If a rise in liabilities is the main cause of this bull market, a persistent bear market can only occur if the passive sector contracts.”

At the end of July, according to Morningstar, $ 7.3 trillion was held in open-ended, passive and exchange-traded funds, which invest primarily in US stocks, ahead of the equivalent active management fund of $ 6.6 trillion. For direct investments, the overall passive part is low. External funding will be considered. Index investing is also growing rapidly in some European countries.

Deluard argued that this shift from active “price sensitive” investors to passive “independent value” investors has helped boost stock valuations.

Its data is the SPDR S & P 500 ETF (SPDR S & P 500 ETF (to spy), The first US ETF was launched, averaging 15.4 over this period.

However, the Schiller p / e index has risen sharply since 2003 and is now 38 times higher than ever.

Deluard doesn’t think the whole rise is due to the growth in passive funds. He said interest rate collapses and huge central bank asset purchases were seen as the global financial crisis “was likely playing a bigger role” in the rise in stock market multiples.

Nonetheless, Delard estimated that the rise in independent passive funds was 27% of the cyclically adjusted increase in the Schiller ratio.

He believes this model also applies internationally and that there appears to be a positive correlation between passive share and valuation in a particular market, at least in terms of relative to selling price.

Moreover, his data suggested that stock corrections would be rarer and prices would fall less deeply. Indeed, passive investing has created “stable buyers who can step in when investor sentiment deteriorates.”

A line graph of the return ratio of small cap stocks to value to the larger ratio of the US stock market (rebase) shows that small caps and value stocks are losing momentum.

Digging deeper, since 2006, the performance of cheap value and small-cap stocks has declined in the United States, reversing the performance premium traditionally provided by these two style factors.

While other factors, such as falling interest rates that benefit growth stocks, may be the cause, Deluard said the trend was “a continued exit from the active sector and tends to be overvalued.” . He argued that value and small caps could be the cause.

Among size factors, he bought the two largest stocks in the Russell 3000 Index at the end of each year, returning 411% since 2014, compared to 143% for the index as a whole, “Winner’s Curse.” I found it was reversed. In the past, this could also be due to a net purchase of large-cap stocks, with investors switching from active funds to passive funds.

Line graph of the returns of the two largest Russell 3,000 stocks and a larger index (rebase) showing that the largest US stock is competing

Deluard acknowledges that he is not in itself an adversary of index funds, but that the passive revolution has brought benefits such as “reduced money spent on mediocre and overpaid active managers and their large distribution structures” .

But he added: “In terms of volatility, it is comparable to forest fire management. Policies to put out all small fires can lead to the build-up of flammable undergrowth, which can lead to larger and more devastating fires.

One of the potential criticisms of his analysis is that even without the advent of passive investing, the financial barriers that have entered the stock market in recent decades have likely been through actively managed funds. I can think about it. In other words, the rating can usually be as high as it is.

Deluard admitted it was a “logical debate”, but he believed active fund managers “would try to develop liquidity more strategically.” If you have a lot of entries, you don’t have to buy high, but you can buy dips. Buy liabilities now.

“Almost $ 1,000 billion has been invested in ETFs over the past year. If you move money so quickly, it will affect the prices, ”he concludes.

Vitali Kalesnik, director of European research at Research Affiliates, a pioneer of smart beta strategies such as value and small caps, agreed that the rise of passive investors was having an “impact” on the market.

“By definition, they are not involved in price discovery. They are price takers. It certainly has consequences, ”he said. “Few of the market players set the wrong prices. This can prolong the bubble and increase the risk of contrarian strategies. “

Kalesnik also attributed the changes in the nature of the market to increased participation by retailers. This means that it has “probably doubled in the last 15 years” and that more and more investors are “trendy and overreacting to news and crowd behavior”. .. .. Increases the likelihood of incorrect pricing. ”

However, Ben Johnson, director of Morningstar’s Global ETF and Passive Strategic Research, said index fund trading activity “still accounts for a small portion of global trading volume, so the hard work of discovering price is always the intrinsic value of the securities. Market players with a clear vision of. “

“I think we’re still a long way from all kinds of sled-dog type scenarios where index funds undermine the pricing process,” Johnson added.

“And when we reach that point, the market will eventually heal itself. New opportunities will be created for active market participants and the pendulum will start to look in the opposite direction. “

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