The growth in indexed strategies over the last three decades has been staggering — in terms of the number of vehicles, the size of the asset pool, and the influence on investment practice. Along with that growth have come concerns about the effects on the pricing of securities in relation to their underlying fundamentals.
As explored in “We Need Some New Terminology (Part 2),” the words “index” and “passive” are used in varied and imprecise ways. In this posting, “indexed” denotes any strategy that is constructed in regards to an index, no matter how broad or narrow it is. ETFs are the vehicle of the moment in terms of attention, but many mutual funds, collective investment trusts, structured products, etc. also fall into that category.
A number of citations below reference articles from — and an online conference hosted by — Alpha Architect, which will hereafter be referred to as “AA.”
The sideshow or the main event?
In a 2017 article, Wes Gray of AA summarized the abstract of a paper, “Can ETFs Increase Market Fragility? Effect of Information Linkages in ETF Markets” (Ayan Bhattacharya and Maureen O’Hara), in this way:
In English, typically market prices are established on the underlying assets and the ETF vehicle simply reflects these values. However, this assumes the ETF vehicle is the sideshow and the underlying stocks are the main event. But what happens when the ETF is the main event and the underlying assets become more of the sideshow? Now the supply/demand dynamics of the ETF vehicle, which may or may not be related to the fundamental values of the underlying assets in the ETF basket, can create manufactured noise, and thus more volatility and instability in the underlying assets. These effects are especially important for the harder-to-trade assets where arbitrage is costly and the supply/demand dynamics from the ETF market are more likely to be based on noise.
While the description references ETFs, the context applies to all indexed strategies: Have they gone from being the sideshow to being the main event?
Much academic research is being focused on the question. For example, this is from an abstract for a paper, “Is There a Dark Side to Exchange Traded Funds? An Information Perspective” (Doron Israeli, et. al):
Our tests show an increase in ETF ownership is associated with: (1) higher trading costs (bid-ask spreads and market liquidity); (2) an increase in “stock return synchronicity”; (3) a decline in “future earnings response coefficients”; and (4) a decline in the number of analysts covering the firm. Collectively, our findings support the view that increased ETF ownership can lead to higher trading costs and lower benefits from information acquisition. This combination results in less informative security prices for the underlying firms.
The materials for the online AA conference, “Democratize Quant,” include those for a presentation by Marco Sammon on his paper, “Passive Ownership and Price Informativeness.” Sammon looked at the changed dynamics surrounding earnings releases and concluded that “average price informativeness [has] declined over the past 30 years and passive ownership is negatively correlated with price informativeness.” (His slides provide an accessible overview of the thesis.)
Mike Green served as the discussant for the paper, saying that the debate is moving from “Is there an effect?” to “How is there an effect?” He thinks that the total exposure to indexed strategies is higher than commonly estimated — and he worries that there might be a nonlinear effect on pricing as the percentage gets even higher.
Price pressure and the effects of popularity
In another of the AA conference sessions, Sam Hartzmark presented fascinating research on his paper (with David Solomon) titled “Predictable Price Pressure.” It revealed the oddity that despite investors knowing well in advance the aggregate amount of dividends to be paid on a given day, the price performance of the market varies in response to the size of those flows, something that doesn’t make sense within the frame of efficient market theory.
This points to a broader question from Wes Gray’s review of the paper:
If there are massive flows into an investment category (e.g., ESG, junior gold miners, market-cap-based passive indexes, etc.) that aren’t tied to fundamentals, the EMH theory predicts no price change. The alternative hypothesis, let’s call it the “price pressure hypothesis,” would suggest that prices will change because providing liquidity and arbitrage capital is costly.
Previous postings from The Investment Ecosystem (including this one) have stressed the importance of “popularity,” as outlined in the book, Popularity: A Bridge between Classical and Behavioral Finance. Investment flows affect the performance of securities and strategies (a factor which is often overlooked during the asset manager selection process). The interesting thing about the analysis of Hartzmark and Solomon is that they extended the concept beyond the strategy level by looking at aggregate dividends and the performance of the overall market.
Taken as a group, indexed strategies are definitely popular — hugely popular. If the “price pressure hypothesis” is valid at all, the size of the asset pool and the enormity of the ongoing flows pose important questions for participants in all corners of the ecosystem.
Indexed investors
With the advent of ETFs, the use of indexed strategies has gone far beyond the core base of investors in traditional passive mutual funds, who looked for broad market exposure that mimicked the market. Now, high-frequency trading firms, hedge funds, long-only asset managers, institutional asset owners, and individuals are using indexed products in all sorts of ways.
For instance, articles in Pensions&Investments and Top1000Funds.com have reported how the Municipal Employees’ Retirement System of Michigan has “found exchange-traded funds to be the optimal vehicle for quarterly rebalancing and tactical shifts across global equity and fixed income,” although the details make that description seem quite understated. One piece says that a third of the assets of the plan is in ETFs; the other says it’s one half. (The headline on a different P&I article: “ETF usage gaining foothold among U.S. pension funds.”)
Another headline — this time on an iShares-sponsored posting in Institutional Investor — asks, “Why is the IWM Small-Cap ETF a Cornerstone for Institutional Portfolios?” It stresses “the potential for incremental return offered by ETF securities lending,” as well as exposure to smaller companies. (A month after that appeared, a very similar argument was made for the large-cap iShares products. Given the unlimited range of indexed vehicles these days, there is no end to the potential supply of similar articles pushing their inclusion in portfolios.)
Asset managers use ETFs too. A study, “ETF use among actively managed mutual fund portfolios” (D. Eli Sherrill, et. al), was reviewed by Tommi Johnsen for AA. The research examined the relative results of benchmark ETFs (those that mimic the performance benchmark of a fund) versus non-benchmark ETFs, regarding liquidity, returns, and risk.
We could go on. In the investment advisory world, there are all sorts of indexed applications that go beyond the acquisition of beta. Advisors sometimes invest in individual specialty ETFs on behalf of their clients, but they also utilize separately-managed accounts and model portfolios, many of which now consist of ETF strategies rather than the individual securities of yore.
Questions
What kinds of investment (in terms of vehicles, tactics, investor types, etc.) in indexed strategies tend to add value? Which ones tend to detract from value?
The available evidence regarding this question is mixed and limited. One paper, “Blessing or Curse? Institutional Investment in Leveraged ETFs” (Luke DeVault, et. al), states that:
Empirical tests suggest that institutional holders of leveraged ETFs predict weak portfolio performance in aggregate, consistent with manager hubris, especially among the set of institutional managers most likely to lack management skill.
A reversion of the popularity — and therefore performance — of thematic and sector strategies seems particularly common. Here’s an exhibit from “Competition for Attention in the ETF Space” (Itzhak Ben-David, et. al):
In what ways are the indexed strategies that your organization employs (or is thinking of employing) inherently “better” than ones created of individual securities? In what ways are they “worse”?
A simple exercise among those involved in the investment process seems warranted, given how indexed strategies are taking over. What evidence can be marshalled in support of those characterizations? It is likely that more and more questions will be asked along that line.
What is the probability that the performance attributes of the strategies you use have been goosed by the popularity of and flows into them?
What are the big-picture ramifications of the tremendous changes in market composition, strategies, and attitudes regarding the use of preset packages of securities versus securities themselves?
Where do you think we are at on this migratory path? What are your game plans for some likely (and unlikely) scenarios in terms of changes in market behavior and the implications for your organization’s investment outcomes?
At what point (if any) will this all have gone too far?
A 2019 article in the Financial Analysts Journal, “The Revenge of the Stock Pickers” (Hailey Lynch, et. al) stated:
When an exchange-traded fund (ETF) trades heavily around a theme, correlations among its constituents increase significantly. Even some securities that have little or negative exposure to the theme itself begin to trade in lock-step with other ETF constituents. In other words, because ETF investors are agnostic to security-level information, they often “throw the baby out with the bathwater.”
It was titled — perhaps over-optimistically given subsequent evidence — “The Revenge of the Stock Pickers.”
Are investors, by virtue of their expanding use of indexed strategies, becoming increasingly “agnostic to security-level information”? That would generally seem to be the case, making all of these questions among the most important ones that an organization can be asking itself.
Published: March 28, 2022
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