Passive investing has bloated the value and volatility of already overweight companies while possibly contributing to flat economic performance, according to a just-released academic paper.
The study titled ‘Passive Investing and the Rise of Mega-Firms’ found flows to US S&P500 index exchange-traded funds over 25 years to the end of 2020 skewed returns and risk to the big end of town.
“During quarters when index funds receive high inflows, the largest firms in the index outperform the index. During the same quarters, index concentration, as measured by, e.g., the combined portfolio weight of the ten largest firms, increases,” the paper says.
“Following the same quarters, the idiosyncratic stock return volatility increases for large firms, and does so twice as much as for smaller firms. Finally, large firms experience higher stock returns than smaller firms when they are added to the index.”
In a trans-Atlantic academic effort, authors Hao Jiang, Dimitri Vayanos and Lu Zheng point to theoretical and empirical evidence of an “amplification loop” skewing mega-stock prices ever-higher during periods of heavy passive flows.
“It also explains why the effects of passive flows on those firms are sufficiently strong so that a switch by some investors from active to passive causes the aggregate market to rise, despite the stocks of undervalued firms dropping in price,” the study says.
Furthermore, the findings imply that larger stocks are less liquid than smaller firms given the disproportionate impact of passive flows on price rises.
Jiang et al also argue the inordinate power of index fund flows may play a role in slowing the pace of economic growth “because large overvalued firms experience the steepest decline in their financing costs but may not have the best investment projects”.
“The misallocation of capital due to such financial distortions can feed into low aggregate productivity, as recent papers have shown,” the study says.
But the results also call into question whether cap-weighted indices, the most common passive fund strategy, need to be “moderated” if the style “leads to welfare-reducing industry concentration or capital misallocation”.
For instance, the paper says index-providers many need to impose “upper bounds” on stock weights “as is the case for some sovereign-bond indices”.
Passive fund holdings of US stocks rose from US$23 billion in 1993 to US$8.4 trillion by 2021, equating to an increase in total US equities funds market share from 3.7 per cent to 53 per cent: index funds represented just 0.44 per cent of the overall US stock market at the start of the period compared to 16 per cent 28 years later.
“The growth of passive investing has been estimated to be more than twice as high when accounting for the increasing tendency by active funds and other investors to stay close to their benchmark indices,” the study says.