Passive investing may be riskier than you think
The massive increase in passive index funds and exchange traded funds (ETFs) has undoubtedly been a good thing for many investors in many respects. These funds often allow investors to gain access to important asset classes in a cost effective way. That said, passive funds are not risk-free. Not only are there important risks to understand about passive funds, but some risks are just now emerging and do not seem to be well understood. For example:
Passive funds still expose you to valuation risk
It bears mention that when markets become overvalued, there is risk for all exposures, including passive funds. Unlike active funds, which can sell or avoid overvalued stocks, most passive funds have no mechanism by which to manage valuation risk. Further, since most major indexes are weighted by market capitalization, valuation excesses tend to get exacerbated. It follows logically that for market capitalization weighted indexes, overvalued stocks are overweighted and undervalued stocks are underweighted. As such, these indexes expose investors to systematic valuation bias which also makes them especially vulnerable to momentum trading. These features were very much in play during the market crashes in 2000-2002 and 2007-2009.
The S&P 500 is not your father's (or mother's) S&P 500
As often happens in markets, the usefulness of an activity decreases as the amount of that activity increases. When the first index funds appeared, they provided very attractive value because they benefited from the fairly efficient pricing created from the competitive buying and selling of actively managed funds. As index funds have proliferated, however, they now comprise a much more substantial share of the market. This means that a much smaller portion of stocks are now purchased or sold on the basis of valuation and instead are purchased or sold on the basis of public sentiment as manifested by money flows to index funds.
A number of important consequences of index proliferation were highlighted in the recent study, “How index trading increases market vulnerability,” by Sullivan and Xiong. Some of the consequences are that, "the average beta for all equity segments [has] ... shifted meaningfully higher," and that, "the diversification benefits [have] diminished dramatically." The authors conclude, "In short, the growth in trading of passively managed equity indices corresponds to a rise in systematic market risk ... All equity investing, indexed or otherwise, is thus plainly a more risky prospect for investors.”
Other consequences
The proliferation of index funds has changed markets in other ways too. For example, index funds rarely vote against board recommendations and this has important implications for corporate governance. Typically, the larger the proportion of index ownership of a stock, the less pressure there is on underperforming management teams to improve.
In addition, research shows that investors in ETFs typically trade much more frequently than other investor groups do. As a result, there is a risk that ETF investors with longer investment horizons may be exposed to volatility caused by short term money flows in their ETFs in addition to the volatility of underlying security prices.
Passive funds still expose you to valuation risk
It bears mention that when markets become overvalued, there is risk for all exposures, including passive funds. Unlike active funds, which can sell or avoid overvalued stocks, most passive funds have no mechanism by which to manage valuation risk. Further, since most major indexes are weighted by market capitalization, valuation excesses tend to get exacerbated. It follows logically that for market capitalization weighted indexes, overvalued stocks are overweighted and undervalued stocks are underweighted. As such, these indexes expose investors to systematic valuation bias which also makes them especially vulnerable to momentum trading. These features were very much in play during the market crashes in 2000-2002 and 2007-2009.
The S&P 500 is not your father's (or mother's) S&P 500
As often happens in markets, the usefulness of an activity decreases as the amount of that activity increases. When the first index funds appeared, they provided very attractive value because they benefited from the fairly efficient pricing created from the competitive buying and selling of actively managed funds. As index funds have proliferated, however, they now comprise a much more substantial share of the market. This means that a much smaller portion of stocks are now purchased or sold on the basis of valuation and instead are purchased or sold on the basis of public sentiment as manifested by money flows to index funds.
A number of important consequences of index proliferation were highlighted in the recent study, “How index trading increases market vulnerability,” by Sullivan and Xiong. Some of the consequences are that, "the average beta for all equity segments [has] ... shifted meaningfully higher," and that, "the diversification benefits [have] diminished dramatically." The authors conclude, "In short, the growth in trading of passively managed equity indices corresponds to a rise in systematic market risk ... All equity investing, indexed or otherwise, is thus plainly a more risky prospect for investors.”
Other consequences
The proliferation of index funds has changed markets in other ways too. For example, index funds rarely vote against board recommendations and this has important implications for corporate governance. Typically, the larger the proportion of index ownership of a stock, the less pressure there is on underperforming management teams to improve.
In addition, research shows that investors in ETFs typically trade much more frequently than other investor groups do. As a result, there is a risk that ETF investors with longer investment horizons may be exposed to volatility caused by short term money flows in their ETFs in addition to the volatility of underlying security prices.
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