This is the eighth part in a series examining the evidence behind the claim that passive investing is causing a bubble.
For the previous part, which asks the question, “Where are all the outperforming active managers?”, click here.
“Every morning in Africa, a gazelle wakes up, it knows it must outrun the fastest lion or it will be killed. Every morning in Africa, a lion wakes up. It knows it must run faster than the slowest gazelle, or it will starve. It doesn’t matter whether you’re the lion or a gazelle-when the sun comes up, you’d better be running.”
This quote, first published in an Economist article in 1985, is strangely appropriate for navigating the modern-day investing savannah.
Traditional active managers, the gazelles, are under increasingly intense pressure to demonstrate value for investors. They’re fighting for survival against their passive predators. Active funds must continually differentiate themselves from passives, while proving that their differentiation is worth paying extra for, if they stand any chance of surviving against the pride of passives nipping at the heels of their herd.
Closet index trackers
Unsurprisingly, it’s the sluggish gazelles at the back of the pack which are being picked off first. It’s that most lethargic form of active management, closet index tracking, which has been the most noticeable victim of passives.
Closet index tracking (or closet indexing) is used to describe funds which claim to have an active style (and so charge active management fees), but whose performance, in reality, is not much different from the benchmark.
Closet index tracking usually arises in one of two ways:
1) Career risk. Having won a particularly large mandate or accumulated enough AUM in their fund, a manager knows full-well that any underperformance against the benchmark will lead to their being fired. Not wanting to be fired, and with the allure of active-level fees to be charged, the incentivised course of action is to slowly morph the fund into one whose returns look mightily similar to the benchmark.
If your fund doesn’t look too different to the benchmark, you’re unlikely to be fired. And you have inertia on your side, too. Changing managers requires a huge amount of time and effort from asset allocators (manager interviews, due diligence questionnaires, idea generation), so sticking close to the benchmark gives allocators little incentive to go through the effort of finding someone to replace you.
The manager avoids being fired and can continue to charge high fees. Sadly, the only people who lose are the investors who could’ve received the same benchmark exposure essentially for free through passive vehicles.
2) The manager is the victim of their own success. Occasionally, a fund will be so successful in outperforming a benchmark that it raises too much capital. The fund becomes too bloated to exploit the inefficiencies that led to its outperformance. It now can’t invest in the opportunities that led to its success, as its investments are so large they now affect the price of the stock.
The fund is forced to invest in new areas of the market which are capable of absorbing the fund’s cash, and which are by necessity more liquid. Over time, the more cash the fund attracts, the more it’s forced to spread its investments into highly-liquid, high-benchmark-weight stocks, and the fund ends up looking like an index tracker.
Often this problem can be solved with closing a fund to new money. But that’s a difficult decision for a fund manager to make. It means turning down new investments, and hence turning down more fee revenue, and hence lower salary and bonuses for the fund manager.
Again, the incentives are skewed towards closet index tracking.
Career risk and misaligned incentives aren’t unique to investing, but both issues have always been particularly pervasive in the industry. As a result, closet indexing has been around for some time.
However, with so much information now at investors’ fingertips, the closet index-trackers are thankfully becoming a dying breed.
Now even retail investors can easily distinguish between a genuinely active fund, and one which walks like an index tracker, talks like an index tracker, but charges active fees. The proliferation of cheap, passive, options has meant that closet index trackers are struggling at the back of the herd.
Although closet index tracking is one example of unskilled active management, there are many others. While passive investing was once akin to lighting a matchstick under such forms of investing, the torrent of flows to passives has turned that matchstick more into a furnace.
With investors becoming more and more savvy, and with the rise of cheap passive options available to everyone, investors are voting with their cash and have been able to punish some of the worse forms of active management. Inefficient, lazy, and unadaptable forms of investing are fast being hunted out of existence, much to the benefit of investors.
As a result, only those active managers who genuinely add value are able to survive. As the unskilled managers are eliminated from the market and replaced with passive investors, highly-skilled active managers make up an increasing share of the market.
Skilled managers compete within a pool of increasingly skilled other managers, and security prices reflect the more informed opinions of a smaller group of more skilled managers*.
By removing the unskilled managers from the market, the rise of passive investing is continuing to increase market efficiency.
Let’s start off by looking at a study by Martijn Cremers, Miguel Ferreira, Pedro Matos, and Laura Starks, titled ‘Indexing and Active Fund Management: International Evidence’.
The authors examine what happened to the active share, cost, and performance of active funds in the face of increased competition from passives, across 32 countries.
They were able to identify the growth of passive investing through tracking the passage of pensions legislation through each country. These pensions acts generally aim to facilitate a shift from government-sponsored defined-benefit (DB) pension systems towards defined-contribution (DC) pension systems and include policy changes designed to increase market competition, such as easy access to mutual funds that offer market exposure (for example, by offering at least one passive fund in the menu of investment options).
The Economist (2014) argues that, with these Pension Acts, “(…) governments are also pushing pension providers to opt for low-cost funds. (….) Such measures make it likely that more investments will flow into tracker funds.”
The authors conclusions were:
- Actively managed funds are more active and charge lower fees when they face more competitive pressure from low-cost explicitly indexed funds.
- The average alpha generated by active management is higher in countries with more explicit indexing and lower in countries with more closet indexing.
- But the marginal returns to active management are lower in markets with more prevalent and cheaper explicitly indexed funds
- Overall, the evidence suggests that explicit indexing improves competition in the mutual fund industry.
This confirms the idea that more indexing leads to:
- The decline of closet index trackers,
- Only the skilled managers surviving,
- Increased market efficiency, as a result.
A second piece of research comes from S&P Dow Jones. The research is titled ‘The Slings and Arrows of Passive Fortune’, and is one I’ve referred to multiple times on this blog.
The authors don’t dive into the closet-indexing idea in great detail – the article dispels a number of different myths relating to passives’ effects on market efficiency (which I’ve covered here). But they do note during their research that:
“It is the least capable active managers who lose the most assets. Index investing thus has the effect of culling the worst active managers… By reducing the number of potentially underperforming active managers, indexing reduces the rewards for those who remain.”
Again, we see that indexing culls the closet indexers and poor active managers, making the market more efficient as only the strong managers remain.
Short selling, passives, and market efficiency
Another, less well-known, way in which passives assist with increasing market efficiency is through their role in facilitating the shorting of securities.
‘Shorting’ a stock involves borrowing a stock, selling it in the market, then buying it back later at a lower price and returning the shares to their original owner – netting yourself the difference between what you sold it for and what you bought it back for as profit.
Shorting helps keeps markets efficient by 1) creating selling pressure on clearly overvalued stocks, and 2) facilitating the execution of arbitrage opportunities where no mispricings should exist. An example of the second scenario would be if a price difference exists between a stock listed on 2 different exchanges. Shorting allows the investor to buy the shares on the exchange where the stock is overvalued, and short the stock on the exchange where the stock is overvalued. The arbitrager has signalled to the market through his short-selling that a mispricing has occurred. As the market realises this mispricing and adjusts the prices accordingly, the arbitrager nets himself a profit, and markets are kept efficient.
However, short sellers face significant constraints. The cost of borrowing a stock to short it can be expensive, sometimes there can be a limited supply of stocks available to borrow for the purpose of shorting – especially for smaller, less liquid stocks – and short-sellers run the risk that their borrowed securities are recalled before the strategy pays off.
This is where passive investing steps in.
Because passive investors aren’t actively buying and selling the stocks in their ETF, the ETF is able to lend the stocks out to short sellers.
As a result, short sellers have an increased supply of shortable stocks, and passive investors boost their returns through short sellers paying them for the privilege of borrowing their stocks.
An interesting paper by Darius Palia and Stanislav Sokolinski, titled ‘Passive Asset Management, Securities Lending and Asset Prices’ investigates the impact of the increase in passive investing on securities lending.
Here’s a summary of their findings:
- Passive funds operate as significant lenders of shares to arbitrageurs and by doing so relax short-sale constraints.
- The effects of passive investors’ security lending activities expand the supply of lendable stock leading to larger short positions, lower lending fees and longer loan durations.
- This effect is significantly larger for passive than for active investors.
- As a result, stocks with more passive fund ownership exhibit faster price discovery, lower likelihood of large negative returns and a smaller value premium.
The result of passive investors lending their stock to short sellers is that constraints on short selling are loosened, so fewer mispricings are allowed to exist. Stocks can be borrowed more easily, at lower prices, and for longer time periods.
Through lending their shares, passive investors are making the market more efficient.
A virtuous cycle for passive investors
As the market share of passive management increases, the market share of active management decreases.
Those active managers most likely to fall victim to passives are, as we’ve seen, the least skilled. The managers which remain are likely to be those with higher skill. As a result, outperforming the market becomes more difficult for those active managers who remain, as they now compete only against other skilled active managers. The suckers have been removed from the table.
Although the absolute skill of the remaining managers is now higher, only relative skill matters for outperformance. The skilful active managers are competing only against each other*. Increasing passive management makes the active management game harder.
It seems logical, then, that the higher the flows are into passives, the better the argument becomes for investing passively. With more unskilled managers being taken out of the market, the more difficult it will be to outperform for the active managers who remain.
Passive flows increase market efficiency, which encourage more passive flows, which increases market efficiency. It seems we’re in a virtuous cycle for passive investing, which is unlikely to end until markets become inefficient enough to reach an active/passive equilibrium.
As I noted in this post, this is unlikely to be any time soon.
The investment landscape is becoming progressively more Darwinian, and those investment styles unable to keep pace in their ability to demonstrate value to investors are being hunted down at an ever-quickening pace.
This is most noticeably playing out with closet index trackers. Once a safe way for a manager to remain employed while collecting high fees, those which have failed to prove their worth and adapt to the threat of cheap passive alternatives are now having their carcasses picked clean by their passive predators.
Not only are passives helping to increase market efficiency through weeding out the poor active managers, they’re also helping by providing a supply of much-needed securities for short sellers to borrow. Stocks can now be borrowed more easily, at lower prices, and for longer time periods – all of which help keep markets efficient.
By removing the least-skilled active managers from the market, the rise of passive investing makes active management an increasingly difficult game. Those skilled active managers who remain are more likely to be competing against other skilled managers. This further strengthens the argument for passive investing, as outperforming in a market with only skilled active managers becomes a progressively more difficult game.
Despite the many critics of passive management claiming that indexing is creating systematic risks through its ability to distort prices, it’s very likely that just the opposite is true. Passives are continuing to play a crucial role in increasing market efficiency.
* As absolute skill levels in the market increase, the variance in returns between managers decreases, due to fewer opportunities to outperform the remaining managers by a wide margin (as everyone is skilled). As a result, outperformance increasingly becomes a function of luck rather than skill. This phenomenon is known as the ‘Paradox of skill’, which will be covered in a later post.