Will Index Investing Destabilize the Financial Markets?

Almost a half century after their introduction, so-called passive investment vehicles like index mutual funds and exchange-traded funds (ETFs) have finally matched their actively managed fund cousins in total assets (see Websites of Interest). The shift towards passive has been especially pronounced since the Great Recession, apparently because many investors have concluded that active managers, like the rest of us, can’t predict the timing of economic downturns with any degree of accuracy. 

Of course, investors who buy individual stocks don’t fall into either the active or passive fund categories, and might have little interest in simply mimicking the return of a market benchmark. But that doesn’t mean that the surge of assets into passive vehicles won’t impact their holdings. None other than John Bogle, the founder of Vanguard and the acknowledged father of indexing acknowledged that, “If everyone indexed, the only word you could use is chaos, catastrophe. The markets would fail.”

“If everyone indexed, the only word you could use is chaos, catastrophe. The markets would fail.”

No one expects passive strategies to ever become quite that dominant, but at a 50-50 split with active portfolios, it’s logical to wonder if chaos or catastrophe could still result from too much money moving in the same direction at the mouse clicks of too few human and virtual traders. 

It’s a concern that has caught the attention of regulators. According to a 2018 research paper from the Federal Reserve Bank of Boston, “some passive investment strategies may amplify price volatility for the assets they hold because these strategies require portfolio managers to trade in the same direction.”

Megan Greene, global chief economist at Manulife Asset Management, alerted investors that “it is reasonable to assume a sustained market correction would lead to stocks that were disproportionately bought because of ETFs and index funds being disproportionately sold.” Hans Redeker, Morgan Stanley’s global head of FX strategy, warned that passive strategies could have a “cascading effect” on stock prices, because fewer active managers would be on hand to stabilize market conditions.

Perhaps most importantly, the Boston Fed study confirmed that index funds cause valuations on some individual stocks (though not necessarily on the broad market) to become distorted. That would make sense, since passive portfolios usually maintain a precise replication of their underlying benchmark, a process that requires buying more shares of stocks that are rising and fewer shares of those that are lagging. (See page 19 of the Fed research paper in Websites of Interest.)

"Some passive investment strategies may amplify price volatility for the assets they hold..."

Paradoxically, the growth of passive investing could eventually mitigate the appeal of its central rationale, i.e., that it’s difficult to consistently outperform the broad market after transaction costs. Indexing reduces the need for company-specific coverage, which theoretically makes the equity market less efficient, and thus creates opportunities for sound stock picking.

Finally, with major online brokers having recently cut their commission rates from next to nothing to literally nothing — and with owners of individual stocks having to pay no operational expenses to hold shares — the cost advantage that indexing once enjoyed has vanished. 

None of this is to disparage passive strategies, which have a rightful place for some investors. Holders of individual stocks, however, should be prepared for periods of heightened volatility as passive portfolios are maintained and rebalanced, and to remain on high alert for valuation distortions as computer-generated trades amplify internal market moves.

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Websites of Interest