Tuesday 14 May 2019 9:46 am

Four ways passive investing has altered the markets

Ever since the first exchange-traded fund (ETF) listed in Europe 19 years ago, passive investing has proved hugely popular.

ETFs are traded like stocks, and simply track the big indices like the FTSE 100 or the Dow Jones, as opposed to having a fund manager cherry-pick individual companies for you.

And with the lowest annual charges of all collective investment schemes, it is hardly surprising that flows into ETFs keep rising. Recent data from research firm ETFGI found that assets invested in the European ETF industry reached $859bn in March – the highest on record.

The London Stock Exchange, which listed its first ETF on the main market in 2000, now has a 40 per cent market share of European trading turnover, and more than 1,100 ETFs listed.

But what impact has this trend for passive investing had on the markets?

1. Bigger, not better

Traditional index funds fully replicate the market, with the weighting of each stock based on the market cap within the index. Essentially, this means that most of your passive portfolio will be invested in larger companies, with no scrutiny of the price or any other factors.

As Jupiter fund manager James Clunie points out: “investors will select assets based on inclusion in an index, rather than evaluating whether or not the share price is appropriate.”

With index approaches growing strongly in recent years, Clunie warns that an increasing number of market players are trading regardless of price.

Some experts think that passive investments are therefore making the markets irrational, potentially creating a momentum effect, which in turn leads to over-inflated asset prices.

Read more: Should investors be worried about an ETF bubble?

2. Domino effect

Passive investing’s simplicity has made the markets more accessible to retail investors, who can now invest in a basket of stocks for a fraction of the cost of actively managed funds.

Ben Seager-Scott, head of multi-asset funds at Tilney Group, sees passive investing as a positive development, but warns that these products bring additional market dynamics, particularly because they can add pressure during times of market dislocation.

The worry is that when markets go down, investors panic and sell out, causing a domino effect as markets fall further.

However, Seager-Scott says: “I reject the idea put forward by some that ETFs are dangerous because ‘amateurs’ could cause market crises and disruption – history has shown that ‘professionals’ in hedge funds and investment banks are more than capable of wrecking the market themselves.”

3. Rebalancing act

As more money accumulates in market-cap index funds and ETFs, the weight of these assets has the capacity to influence market behaviour.

According to Howie Li, head of ETFs at LGIM, this is increasingly evident when you look at what happens just before the reshuffling of popular indices. He explains that passive fund houses collect data which preempt the announcements about additions and deletions of companies in indices, essentially giving them a head-start when rebalancing their portfolios.

“Opportunistic traders can act in advance of the implementation date of the changes,” Li explains.

Generally speaking, this mechanism can prompt swings in prices around the date that indices rebalance.

According to LGIM, rebalancing of global equity indices every quarter between February 2015 to May 2018 meant, on aggregate, other investors lost up to 6.5 basis points of performance because prices moved.

4. Passive aggressive

Passive funds have also altered the wider asset management industry.

Seager-Scott says that the growth in the passive market is helping to reform the active market. “The provision of ultra-low cost trackers is helping to bring down the cost of active management, forcing fund managers to really justify their fees in a way that was simply not the case a few years ago.”

Essentially, this focus on value will push poor-performing and mediocre active managers out of the market.

“Efficient markets require active participants,” he says, suggesting we could see the market concentrate down to a smaller number of exceptional, high conviction fund managers, getting rid of closet trackers. “The rise of passive investing will be a driving force for this.”

Passive funds like ETFs will continue to reshape the investment landscape, and this will bring both challenges and opportunities.

Seager-Scott concludes: “Investors should ensure that they fully understand the instruments they are using, while market regulators should remain alert to the developing dynamics in the market.”