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John Engle
John Engle
Articles (610) 

Index Funds: Too Popular for Their Own Good?

The unprecedented abundance of passive capital has transformed the stock market in fundamental ways

February 17, 2021 | About:

On the back of things such as the widespread use of pension and retirement funds as well as the increased accessibility of investment banking, index funds are more popular now than ever, with passively invested funds having surpassed actively invested funds.

Indeed, they may have become too popular for their own good. They have gotten so big that it now appears they can no longer do what they were designed to do: passively buy and sell securities at prices set by active market participants.

There are seveal ways in which this could become a real problem, not only for passive allocators but for the market as a whole.

A fundamental transformation

In 2018, StoneX Group Inc. (SNEX) released a landmark report on index funds' ability to impact the prices of securities. StoneX found that stocks that appear in fewer indices than average tend to underperform while stocks that appear in indices more frequently tend to outperform.

By inducing abnormal price behavior in a multitude of individual securities, index funds have become a threat to market efficiency:

"Price discovery would be impossible in a fully passive world. The more interesting question is whether we have reached this passive tipping point…Index funds are no longer passively replicating capital markets, but that they are transforming them in a possibly less efficient manner."

What this means is that index funds are no longer merely free riders. Instead, they have become an active detriment to efficient price discovery. That has all the makings of a potentially damaging negative feedback loop – one that could threaten not only efficient price discovery and capital flows, but the stability of the entire stock market.

As a result of index funds' growing power to affect stock prices, those active investors and analysts still engaged in the price discovery process will face an ever harder task, which in turn risks encumbering the overall performance of the market on which the index funds rely.

Beyond the tipping point

The more capital that flows out of the active investing sphere and into the passive market, the less efficient the price discovery process will be. Since that has been the trend of capital flows for some time, and with no end in sight that I can identify, I suspect it will persist for at least the foreseeable future.

The increasing overabundance of passive capital certainly appears to have emerged as a real threat to market efficiency. Of course, markets were prone to bouts of inefficient capital allocation long before index funds rose to their current level of prominence. In 2001, historian Ron Chernow wrote about the dot-com bubble in similar terms:

"Think of the stock market in recent years as a lunatic control tower that directed most incoming planes to a bustling, congested airport known as the New Economy while another, depressed airport, the Old Economy, stagnated with empty runways. The market has functioned as a vast, erratic mechanism for misallocating capital across America. Let us be clear about the magnitude of the Nasdaq collapse. The tumble has been so steep and so bloody — close to $4 trillion in market value erased in one year — that it amounts to nearly four times the carnage recorded in the October 1987 crash."

While the market bloodbath of 2001 was bad, the current prevalence of passive capital in the market could make the next crash even worse. The next bear market could trigger another negative feedback loop, a self-reinforcing rout driven by passive flows exacerbating the downtrend, which could in turn spur allocator drawdowns. Such a scenario already played out in February and March last year, though the drawdown was mitigated by trading halts and prices were then propped up as the Federal Reserve flooded the market with liquidity.

Weakening corporate governance

Good corporate governance is a cornerstone of public capital markets. Unfortunately, the proliferation of index funds and passive investment appears to have weakened corporate governance significantly.

Because they track the whole market, they rarely have time or inclination to focus on corporate governance of individual companies. As Bloomberg's Matt Levine observed last month, this trend has accelerated over the past couple of years:

"Basically before 2019, index funds had to recall their shares to vote on 'material items'; after the 2019 guidance, they could conclude that the stock-lending revenues were more important than voting. So index funds started lending out more shares, leaving them on loan during big votes, and voting fewer shares—occasionally with the result that companies made decisions that the index funds opposed, because small concentrated shareholders voted for it and big indexers didn't vote... Quasi-indexers are the big long-term investors who own most of the stock market as fiduciaries for their clients. They are supposed to be good stewards of their clients' money and good overseers of corporate behavior. If they give up their voting rights, in exchange for a tiny bit of money, then they are—arguably—not doing their jobs right."

Index funds and the "quasi-indexer" fiduciaries have proven to be far less engaged in the day-to-day management of the individual securities in their market-tracking portfolios. That may work fine most of the time, but when it becomes the norm, it opens the door to the sort management malfeasance that large external shareholders are supposed to identify, deter and prevent.

My verdict

As any experienced value investor knows, wherever there are market inefficiencies, so too are there opportunities. Indeed, somewhat ironically, even as a growing number of active investors have despaired at the seemingly irreversible macro trend toward passive allocations, the opportunities to generate market-beating returns have actually increased.

Ultimately, even if the oversaturation of passive capital proves persistently problematic for markets as a whole, it may well expand the universe of potential bargains.

Disclosure: No positions.

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About the author:

John Engle
John Engle is president of Almington Capital Merchant Bankers and chief investment officer of the Cannabis Capital Group. John specializes in value and special situation strategies. He holds a bachelor's degree in economics from Trinity College Dublin, a diploma in finance from the London School of Economics and an MBA from the University of Oxford.

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