7 Disturbing Outcomes for Stock and Bond Markets Caused by the Rise of Passive ETF Funds

 In Bond Investing

etf funds

ETF funds have become increasingly popular in recent years due to their passive nature. They supposedly allow investors to enjoy a hands-off approach to building wealth.

However, hedge funds are in real trouble. Barclays points out that the average monthly alpha for hedge funds has actually decreased to -0.07% since 2011.

As you can see from the charts below, passive and active investing has dramatically changed in recent years.

etf funds

The chart below illustrates the plunge in hedge fund alpha from 2010 through 2016.

etf funds

Combine that with the fact that hedge fund managers are having to revise their rules to recapture investors running to other options, and you begin to see the problem.

However, it doesn’t end here. In fact, Nikolaos Panigirtzoglou of JPMorgan and previously of Bank of England points out that there are some potentially devastating outcomes looming for stock and bond markets around the world.

ETF Funds Foster Deeper Plunges and Shorter Growth

One of the predictions made is that global markets will see deeper troughs and slower growth periods due to ETF funds and passive investing.

Panigirtzoglou points out that not only will this shift build on the herding behavior of investors, but will actually increase the repercussions of current market movements, as the stock market is predicted to have reached its ultimate peak and will soon begin sliding into a 40-year trough.

Retail Investors Are Becoming More and More Important

Retail investors are altering the landscape. In comparison to institutional investors, retail investors have a much shorter investment time horizon, and that creates more rapid movement in the market.

This can create pressure on active managers to run down their cash balances if retail investors opt to withdraw active funds.

Investments Are Becoming Homogenized

We’re seeing something of a consolidation in today’s markets. The more passive investing occurs, the more investments become concentrated into just a handful of larger options.

This has correlations in the real world – think about the conglomeration of particular markets – smartphones in the US, for instance. While there are multiple manufacturers, Apple and Samsung have the lion’s share of the sales. This shift in the stock and bond markets can increase systemic risk and increase the effects of variation.

Smaller Companies Are Likely to Suffer

One of the most frightening prospects of the shift toward passive investing with ETF funds is the fact that smaller companies are likely to suffer, some of them greatly.

This is due to the fact that passive investing tends to favor large caps. This can create a misallocation of cash flow away from those smaller companies that really need it.

In addition, there is the very real possibility that passive investing will starve small companies while creating bubbles within larger companies, putting everyone at risk.

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Market Efficiency Is Already Suffering

Financial markets are not that efficient even at the best of times, and the surge of passive investing in ETF funds has led to what is definitely not the best of times.

Look for market efficiency to drop even further. As the trend increases, you’ll see efficiency really start to plummet.

The reason for this is that passive investing actually crowds out skilled active managers who create the efficiency in the first place. It’s a snowball effect.

Stock Inclusion Flows Are Increased by Proliferating Index Funds

As index funds continue to proliferate, stock inclusion flows also increase. This creates market movement due to changes in those indexes that are far more pronounced than they should be.

This generates overly strong penalties to companies that leave the index and also fosters overly strong gains for companies entering the index.

Corporate Activism Will Decline

Passive investing is just that – passive. Investors who follow this method with ETF funds generally don’t pay much attention to corporate governance.

This can create the perfect environment for corporate activism to decline. It can affect virtually all areas of a company, from transparency to community outreach and everything in between.

With that being said, passive fund firms can lend their weight to the situation, encouraging companies toward greater activism in some cases.

When Everything Is Said and Done

Ultimately, markets evolve and change over time naturally. How is the shift toward ETF funds, hedge funds and passive investing so different? Panigirtzoglou points out that the current trend will foster greater risk and more brittleness in the market.

This is directly due to the increased systemic risk and the concentration of investments in just a few large products.

Of course, the trend also promises to create worse crashes that last longer. Periods of strong market performance will shorten, and the lulls between them will deepen and lengthen, creating an environment that does not foster success for any investors.

When the inevitable correction occurs, passive investors will see significant losses as the cash flows away, and toward active investments.

And, remember, the market is already poised to tip, and to tip hard. We’ve reached peak valuation, and the inevitable plunge toward the bottom is at hand.

Finally, there is the very real potential for reduced efficiency. As passive investing increases, skilled active managers are excluded, leaving fewer experienced hands at the helm.

The reduced efficiency also creates an environment ripe for extracting arbitrage profits by the remaining active managers.

What should investors do to safeguard their wealth and insure their financial future?

Using an asset dedication approach with a heavy concentration on high-quality corporate bonds can be immensely beneficial, allowing investors to weather the gathering storm and help to ensure a comfortable retirement.
Bond Investing Fundamentals

Sergey Sanko
Sergey had started an IncomeClub after years of being an investment advisor for high affluent investors and managing fixed income securities. He is the lead investment advisor representative and holds a Series 65 license. Sergey earned his Executive MBA degree from Antwerp Management School.
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