NEW YORK - While the switch from an active to a passive fund may make sense for a given investor, does the collective torrent of funds surging in the index-tracking space create the risk of the systemic crisis?
The question is taken seriously by Federal Reserve Bank of Boston assistant vice president Kenechukwu Anadu and three Fed economists in a paper that was recently published by the CFA Institute’s Financial Analysts Journal.
Entitled ‘The Shift from Active to Passive Investing: Risks to Financial Stability?’, the paper examines risk along four tracks: Liquidity, volatility, asset management industry concentration, and asset valuations and correlations.
Starting with liquidity, Anadu and his co-authors report that ETFs (which are almost exclusively passive vehicles) should cause less concerns about ‘destabilizing firesales’ than mutual funds, for the technical reason that most ETFs are redeemed for baskets of securities rather than for cash. Indeed, most ETFs managed to hold up quite well through the March crash.
The authors also determined that passive mutual funds are less likely than their active peers to see large outflows after periods of poor performance, perhaps because an investor in a sliding active fund may think they should pick a different manager, whereas a passive fund should never meaningfully underperform its benchmark.
For these two reasons, the Fed authors concluded that the active-to-passive shift reduces, rather than increases, systemic risks around liquidity and redemptions.
Moving onto the concern that the shift to passive could increase volatility, the authors cite research showing that both leveraged and inverse ETFs are forced to trade in the same direction as that day’s market moves. (This may be counter-intuitive for inverse ETFs, but consider an inverse fund holding a short position; when the underlying asset rises, the short position grows and thus must be reduced by ‘covering’ some of the short, which is equivalent to buying the asset.)
Whether these ‘geared’ ETFs can properly be called ‘passive’ is a matter of some debate, and either way, they are not currently significant in size. Still, the authors conclude that risks around increased volatility are indeed higher due to the shift away from active management.
The third potential risk comes from the increasing concentration in the asset management industry that the rise of passive investing may promote. The authors show that passive funds are much more concentrated than active funds – which makes sense given their economies of scale, the lack of capacity constraints for the underlying strategies, and the lack of differentiation among products.
The wind-up is that the overall asset management industry has become more concentrated overall – which may be a cause for concern. For one thing, the authors note the risk that ‘a significant idiosyncratic event [such as a cybersecurity breach] at a very large firm could lead to sudden massive redemptions from that firm’s funds and therefore potentially from the asset management industry as a whole.’
Finally, the authors consider the concern that the flood of investment dollars into index-tracking funds is creating ‘greater co-movement of returns and liquidity,’ which could in turn ‘have repercussions for financial stability by broadening the impact of shocks to asset markets.’
Michael Burry, star of Michael Lewis’s The Big Short, made headlines in 2019 for warning of a passive investing bubble. In considering that possibility, the Fed authors soothingly conclude that such a bubble would be ‘limited,’ given that index-inclusion effects seem only to have a moderate effect on equity valuations.
Addressing the question of different securities’ increased tendency to move together as a result of the active-to-passive shift, the Fed authors find the evidence to be mixed. While the co-movement of stock returns has apparently risen over the past several decades, it is not clear that passive investing is responsible.
Overall, the Fed authors mark the shift’s impact on financial stability risks around asset valuations, volatility and co-movement as ‘uncertain.’
The bottom line? Anadu and his colleagues seem not to have found any red-flashing warning signs triggered by the rise of passive investing.
Still, if Fed economists become more worried about asset management industry concentration, greater regulation of major managers could follow.