Friday, 9 September 2011

Passive Indexing Trend Leading to Increased Investment Risk

Too much of a good thing for individuals can be bad for everyone collectively when it comes to passive index investing. James Xiong and Rodney Sullivan explain how this has come about in How Passive Investing Increases Market Vulnerability, available for download here at and here at SSRN.

Through a series of statistical tests on US equity data back to 1979, they show how the take-off of passive index investing since 1997 is strongly associated with their disquieting stock effects:
  • "... the rise in passive investing meaningfully corresponds to a decrease in the ability of investors to diversify risk in recent decades" and
  • "... the diversification benefits of equity investing have decreased for all styles of stock portfolios (small, large, growth, or value). The decline in diversification benefits can couple with increased market volatility and firm-specific volatility."
Passive index investments in mutual funds and ETFs by late 2010 reached about a 1/3 share, or $1.2 trillion, of the total in such funds of $3.5 trillion - active investment funds makes up only 2/3 of the total. (The paper also tells us that institutional investors now hold 70% of US equity stock vs 44% in 2000 and only 24% in 1980.)

The chart below from the paper shows the vertiginous rise in correlations between pairs of stocks. Note how the more passively indexed segment, the SP500 large caps, has higher correlations than smaller caps, the non SP500 stocks in the chart.

They checked that the effects were not only manifest during the recent periods of extreme market crisis - the dot com crash in 2001/02 and the credit crisis crash in 2008/09 - when all asset class correlations rose significantly. The same pattern of rising correlations continued through the other more normal years of the study period.

There may still be value for individual investors to buy those passive index funds but the free lunch of passive diversification now appears to be merely selling at a discount. One thing for sure, as I tried to suggest in the thought experiment post What Would Happen if Everyone Did Passive Indexing? the success of passive indexing, when it becomes big enough, does have an effect on markets. In another post last year, Index Investing Becoming a Victim of Its Own Success, I noted research by Jeffrey Wurgler on the S&P 500 that reaches similar conclusions. No wonder the avant-garde of risk-aware, efficiency-aware institutional investors is moving away from cap-weight passive index investing, some to private equity direct investing, such as the big pension funds and others to alternative-weighting indices.

1 comment:

Rob Bennett said...

This is an important topic. I'm glad you wrote it up. I certainly believe that the popularity of passive investing has to affect the markets.

I see a brighter future for index investing than what is suggested here. If 90 percent of investors followed passive strategies, the remaining 10 percent would be enough to keep the relative prices of different individual stocks in order.

In the long run, passive investing will lower volatility. We need to educate passive investors of the need to adjust their allocations in response to valuation shifts. When this message gets out, both overvaluation and undervaluation will become logical impossibilities and market prices will become self-correcting. Price volatility will be reduced to a tiny fraction of what it is today.

Good piece.


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