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Passive investment blamed for inflating stock market bubble

Studies claim that the trillions of dollars that have flooded passive funds in recent years have inflated valuations, radically reshaping the US stock market and isolating it from the persistent bear market threat.

Vincent Deluard, a global macro strategist at brokerage firm StoneX, said unprecedented trends led to structurally high equity valuations separated from corporate fundamentals, benefiting large and growing stocks at the expense of value and small cap stocks. Brought about, resulting in shorter lifespans and shorter lives, claiming market modifications.

“The predominance of evidence suggests that the rise of passives has played a major role in the stock market bubble over the last decade,” said Deluard. “If a rise in passives is the main cause of this bull market, a persistent bear market can only occur if the passive sector shrinks.”

As of the end of July, according to Morningstar, $ 7.3 trillion was held in passive open-end and exchange-traded funds, which primarily invest in US equities, ahead of the equivalent active management fund of $ 6.6 trillion. For direct investment, the overall passive share is low. External funding will be considered. Index-based investment is also growing rapidly in some European countries.

Deluard argued that this shift from “price-sensitive” active investors to “value-agnostic” passive investors contributed to boosting equity valuations.

His data is the SPDR S & P 500 ETF (SPDR S & P 500 ETF (spy), The first US ETF was launched, with an average of 15.4 during this period.

However, Schiller’s p / e index has risen sharply since 2003 and is now 38 times higher than ever.

Chart: Is the trend over?

Deluard does not believe that all this rise is due to the growth of passive funds. He said interest rate collapses and huge central bank asset purchases were witnessed as the global financial crisis “probably played a bigger role” in increasing stock multiples.

Nonetheless, Delard estimated that the rise in value-agnostic passive funds accounted for 27 percent of the cyclically adjusted increase in the Schiller ratio.

He believes this pattern applies internationally as well, and there appears to be a positive correlation between passive share and valuation in a particular market, at least in terms of ratio to selling price.

In addition, his data suggested that stock market corrections would be more rare and prices would fall more shallowly. This is because passive investment has created “stable buyers who can intervene when investor sentiment deteriorates.”

A line chart of the return ratio from small cap / value stocks to the broader US stock market (rebase) ratio shows that small caps and value stocks lose mojo.

Further digging, since 2006, the performance of cheap “value” and small cap stocks has declined in the United States, reversing the return premium traditionally provided by these two style factors.

While other factors, such as falling interest rates that benefit growth stocks, may be the cause, Deluard said the pattern was “a continuous outflow from the active sector and tends to be overvalued.” He argued that value and small caps could be the cause.

Among the size factors, he bought the largest two shares in the Russell 3,000 index at the end of each year, returning 411% since 2014, compared to 143% for the index as a whole, “Winner’s Curse. I found that was reversed. In the past, it could also be due to a net purchase of megacap shares as investors rotate from active funds to passive funds.

Line chart of returns for the two largest stocks in Russell 3,000 and a wider index (rebase) showing that the largest US stock is competing ahead

Deluard acknowledges that it is not an opponent of index tracking funds in itself, but that the passive revolution has brought benefits such as “reducing the money spent on mediocre and overpaid active managers and their large distribution structures.”

But he added, “In terms of volatility, it’s likened to forest fire management.” Policies aimed at extinguishing all small fires can lead to the accumulation of flammable undergrowth, which can lead to larger and more devastating fires.

One of the potential criticisms of his analysis is that even without the advent of passive investment, the financial barriers that have entered the stock market in recent decades have probably entered through actively managed funds. I can think of it. In other words, the rating can generally be as high as it is.

Deluard admitted that this was a “logical debate,” but he believed that active fund managers would “try to develop cash more strategically.” If you have a lot of inflows, you don’t have to buy high, but you can buy dips. Buy passives right away.

“Nearly $ 1 trillion has been invested in ETFs over the past year. If you move money so quickly, it will affect prices,” he concludes.

Vitali Kalesnik, European research director at Research Affiliates, a pioneer in smart beta strategies such as value and small caps, agreed that the rise of passive investors had a “impact” on the market.

“By definition, they aren’t involved in price discovery. They’re price takers. It definitely has consequences,” he said. “Few market participants are fixing incorrect pricing. This can prolong the bubble and increase the risk of contrarian strategies.”

Kalesnik also attributed changes in the nature of the market to increased retail participation. This means that it has “probably doubled in the last 15 years,” and more and more investors are “prone to fashion and overreact to news and crowd behavior.” .. .. Increases the likelihood of incorrect pricing. ”

However, Ben Johnson, director of Morningstar’s Global ETF and Passive Strategic Research, said that index fund trading activity “is always a small part of the world’s trading volume, so price discovery hard work is always the intrinsic value of securities. Market participants with a clear view of. “

“I think we’re still a long way from all sorts of tail wag dog-type scenarios where index funds undermine the pricing process,” Johnson added.

“And when we reach that point, the market will eventually heal itself. New opportunities will be created for active market participants and the pendulum will begin to look in the opposite direction.”

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