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THE WORLD’S central bank has paved the way for more scrutiny on the impact of exchange-traded funds (ETFs) on stock markets. This, however, will not slow down the ETF juggernaut any time soon.
February was a roller-coaster month for US stocks.
In this column early last month — 3 Reasons To Explain The Stock Market’s Crazy Run — we cited the continuing purchases of ETFs as one of the reasons for the rise of US stocks. Gains were hit by a 3,200-point decline in the Dow Jones Industrial Average (DJIA) over a period of two weeks. This was followed stocks recovering about 75% of that decline before tumbling close to 700 points in the last two trading days of February. We wrote at the time:
ETFs form a significant percentage of all stock transactions and some see them as having distorted share prices because component stocks of ETFs are bought without research and any regard for their valuations. As such, money moving into ETFs will, by design, lift the stocks that make them up, regardless of underlying fundamentals. This can be likened to a teacher giving everyone in the class an A for an exam regardless of how well they did in the exam because it makes the whole class, and the teacher, look good.
ETFs Growing In Popularity
It should be noted that ETFs and index funds remain very popular with institutional investors and are, by most accounts, growing in popularity. At the same time, many retail investors are now engaged in a strategy of tracking and mirroring what the big players like institutional investors do. This adds impetus to ETF and index fund purchases.
Further, in the growing robo-advisory services space, portfolios recommended to retail investors predominantly use ETFs and index funds as their underlying components. Another layer of ETF demand is thus added.
ETFs and index funds are categorised as passive investments as they are marked by a minimum of transactions that help to keep fees low. This, in turn, has a positive impact on their returns, and hence their attractiveness to investors in their search for yield.
This is in contrast with active investments where fund managers actively pick and choose stocks according to their funds’ mandates, monitor their investments and tweak their holdings as and when they see fit to keep within the parameters of their mandates. These activities tend to put upward pressure on fees which in turn weighs on returns. Sometimes, active managers can outperform the market, but in the long run, they typically fight a losing battle.
We revisit our column from a month back because the Bank for International Settlements (BIS), which is essentially the central banks’ central bank, published a special feature in its BIS Quarterly Review, March 2018 titled “The implications of passive investing for securities markets.” It was written by BIS economists Vladyslav Sushko and Grant Turner.
One of the key points put forward by the authors is that passive investments can contribute to the pricing inefficiencies and the misallocation of capital. They note that “passive portfolio managers have scant interest in the idiosyncratic attributes of individual securities in an index. They do not devote resources to seeking out and using security-specific information relevant for valuing individual securities. In effect, they free-ride on the efforts of active investors in this regard. Hence, an increase in the share of passive portfolios might reduce the amount of information embedded in price.”
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The authors’ comments allude to the potential for inefficiencies of stock markets caused by passive investments, which is quite a revelation coming from an entity like the BIS.
Now, in less developed markets, information asymmetry helps people to make money on stocks until all the information pertaining to a stock is reflected in the share price. In contrast, developed markets are considered to be efficient apart from a few pockets of information asymmetry which are typically priced in very quickly.
This is another reason that ETFs have gained in popularity—there is little or no information asymmetry left in markets to leverage upon.
This is one of the financial market-related outcomes of the ubiquity of the internet and social media. As such, the notion that ETFs themselves can potentially precipitate inefficiencies is a significant one.
However, at present, the authors note that while passive funds have made substantial inroads into the universe of investment vehicles available to end-investors, their holdings as a share of total outstanding securities remain at a relatively low level due to the sizeable holdings of other non-fund investors.
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“The share of securities held by passive fund portfolios is highest for the US equity market, but it still amounts to only around 15% of the total. Shares of passive funds in other equity markets are lower, at about 5% or less,” they write.
The special feature concluded that the effects of passively managed funds could become significant in broader markets if the passive fund management industry continues to expand. It is likely that if passive investments can create information asymmetry and lead to inefficiencies in markets that can be arbitraged, regulation will be considered when the size of ETFs and index funds as a proportion of total investment holdings in markets expand to higher levels.
This will not happen any time soon. As the passive investment base grows, growth will likely decelerate. Nonetheless, retail investors playing the follow-the-leader strategy should be on the alert for regulatory risk signals. These will come from institutional investors starting to sell their passive investments hastily, causing net ETF inflows to reverse to outflows.
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