To be clear, there is no question as to whether the epochal active-to-passive shift is a positive development for markets, on balance.
But this is one situation where the throwaway phrase “on balance” should not be summarily dismissed as a perfunctory caveat.
There are ramifications for market functioning when everyone is a passive investor. The list of such ramifications is long indeed, but one of the oft-repeated worries is that the proliferation of passive strategies (and even defining the term “passive” is no longer straightforward) is having a deleterious effect on price discovery.
ETFs almost by definition encourage herding and indiscriminate buying. It stands to reason that if the buying is indiscriminate on the way up, the selling will be similarly indiscriminate on the way down. Indiscriminate capital allocation invariably leads to misallocated capital. It also encourages mindless participation in markets and discourages stock- and sector-level analysis.
Of course, passive investing has also i) driven fees to (essentially) zero, ii) served to protect investors from an industry that can be predatory, iii) helped encourage long-term thinking and iv) contributed to healthier investment decisions by the masses. In many ways, the rise of passive is the best thing since sliced bread.
But, as with anything else, it’s possible to have “too much of a good thing” and some worry we’re approaching that threshold with passive investing.
One underappreciated aspect of this debate is the extent to which some of the negative side effects associated with the passive shift conspire with other fixtures of modern market structure to impact liquidity.
That’s something that comes up in BofA’s lengthy 2020 equity outlook.
Lest anyone should get the wrong idea, the bank is generally bullish. Their year-end 2020 target for the S&P is 3,300.
But if you manage to make it all the way to page 71 of the 125-page tome, you’ll find a discussion around liquidity risk.
“Amid recent signs of liquidity risks in various markets, we worry about an unlikely area of liquidity risk: the S&P 500, the equity benchmark perceived to be more liquid than most”, the bank writes.
The problem isn’t stocks themselves, or the benchmark, of course. Rather, the problem is modern market structure.
As the bank writes, “trading dynamics have changed, and it is well documented that trading volume of large cap US stocks has been increasingly shifting to non-fundamental investors [whether that’s] quants, passive, high frequency, etc.” When you throw in the change in prop trading behavior precipitated by the post-crisis regulatory regime, you end up with trends like these:
“Average trading volume for S&P 500 stocks has been falling for years. Banks no longer provide the same liquidity as pre-GFC”, BofA goes on to say, adding that the predictable result “is a bid-ask spread for the average S&P 500 stock that is close to a multiyear high”.
But wait, there’s more.
The bank then flags “a risk no one is talking about” – namely the extent to which the hunt for yield has forced folks to lean into the illiquidity premium in order to squeeze out yield in a world devoid of it.
“If pensions, passive, hedge [and] mutual funds have piled into private equity plus a narrow sleeve of megacaps, watch for public market liquidity risks”, BofA cautions, before getting a bit more specific. To wit:
Pension funds’ exposure to private equity/illiquid assets has risen demonstrably amid a reach for returns. But any disturbance to private markets (IPO friction, funding shocks via credit or rates) could force pensions to raise cash for distributions by selling the more liquid parts of their portfolios, namely public equities.
All of this underscores the risk to liquidity from modern market dynamics.
And it should be considered in conjunction with the feedback loops we’ve discussed here before, namely the interplay between liquidity, volatility and systematic flows.