In the 10 years since the 2008 crash, the ‘passive-aggressive’ tendencies of large index funds have reshaped how modern capitalism operates
The capacity for disruptive innovation within finance is part of its continued appeal for political economists post-crisis, whether it is the speed of algorithmic-trading, the growth of fintech or the darker recesses of the shadow banking sector. But the focus on the fast, the novel and the obscure can distract us from slow, mundane developments which sometimes shape economic processes and outcomes more fundamentally. As we approach the ten-year anniversary of Lehman Brothers collapse, it is worth reflecting on how the economic landscape of the US and many other Western nations has been affected less by the froth and bubble of innovation and rather more by two familiar slow-moving glaciers: the effects of central bank interventions on debt and asset markets, and the growth of passive investment strategies, primarily index mutual funds and exchange traded funds on equities.
The imagery of the glacier is useful in understanding processes and outcomes in two respects: first of all, glaciers do not yield to the landscape, the landscape yields to them and second, once in motion, the direction of glacial momentum is almost inexorable – objects which provide potential resistance tend to get carried with the flow and deposited as drift somewhere further downstream.
The story about the central bank glacier is well-known – the mass of monetary interventions after the financial crisis depressed bond yields and term premia; whilst the Fed kept interest rates low. This broadening and deepening of central bank involvement in the economy forced pricing in a range of debt and asset markets, leading to a transformation in the liability structure of US non-financial corporations. Publicly listed firms issued bonds and (bar an equity splurge to shore up balance sheets post-Lehman) aggressively de-equitised through buybacks (Figure 1). At the same time the abundance of cheap debt led to the growth of private equity megafunds and a preference for inorganic over organic growth across the board, which is why goodwill has grown from $1.8 trillion to $2.9 trillion in the S&P500. Cynics who bet against the bank, anticipating runaway inflation or market reversals, had their positions carried in the opposite direction and unceremoniously dumped.
But arguably the shift from active to passive investment strategies may be doing something similar in equities markets. Passive investment funds embody the logic of the efficient market hypothesis – that because share prices incorporate all available market information, no single investor can ever outperform the market over the long term. Passive investment funds therefore do not trade individual stocks on the basis of their fundamentals, but rather assume that the market is ‘right’ and so only buy or sell a stock when the composition of an index like the S&P500 changes. By stripping out the costs of fundamentals analysis and active trading, passive index funds compete on price, offering a low-cost, low-fee model to investors.
The growth of passive investment is quite astonishing. Between 2007 and 2016, actively managed funds in the US recorded outflows of roughly US$1,200 billion, while index funds received inflows of over US$1,400 billion. By 2017 the Big Three passive asset managers – BlackRock, Vanguard, and State Street – held nearly $11trillion assets under management – three times the value of the global hedge fund industry. In 88% of S&P500 firms, the Big Three seen together as one investor block are the largest shareholder (see Figure 2). It is estimated that only about 10 per cent of US equity investment is now done by active, fundamentals-based traders.
Figure 2: Network of ownership and control by the Big Three in U.S. listed firms
Source: Fichtner, Garcia-Bernardo & Heemskerk 2017 based on Orbis database. Note: Only ties of >3% ownership are included
But the growth of passive investment raises philosophical questions about what information is ‘in the price’ and what drives it? What happens when passive funds become so large that they are the market, or at least are able to affect market pricing significantly? A recent FT article by John Plender explains that the results can be self-fulfilling or circular.
‘In indices weighted according to market value, net inflows into passive portfolios result in the share of overvalued stocks in the index increasing in a rising market …Inter alia, the growth of passive investing must lead to greater correlation of indexed securities and a reduction in company-specific information contained in stock prices.‘
If stock prices of firms that are constituents of an index correlate to that index rather than underlying firm performance, then the price mechanism is not functioning fully. Ironically it may be the case that passive investors require strong active investors in the market for their investment strategies to work; to avoid their investments becoming self-fulfilling.
This is worrying because it implies that in debt markets and equity markets prices are being shaped by monolithic forces that are softening the kind of information that capitalists might be expected to trade on. If this is capitalism, it is a very strange form where the traditional role of markets and prices as part of a dynamic, self-adjusting system have given way to the slow, unyielding momentum of two glaciers which now carve their impressions into the economic landscape.
There are two risks posed by the latter of these glaciers. A recent Bank of England working paper assessed the impact of passive investment strategies on bond markets. They found that in the short term those strategies temper endogenous volatility, particularly the tendency for momentum or value investors to over- or under-shoot in response to news-flow (in much the way described above). However, over the medium to long term they argue that passive strategies significantly increase the tail risk of large yield dislocations when exposed to more serious exogenous shocks.
We can quibble about whether ruptures of this sort are endogenous or exogenous, but if we transpose this argument about bonds to equities – it suggests that when passive strategies become dominant forces within markets, they may create the conditions of their own success, because passive funds have the capacity to both benefit from and constitute a low-volatility upswing. However, this comes at the risk of bubble-formation and a messy unravelling at times of crisis if funds try to exit increasingly illiquid positions in tandem, leading to the kind of distressed selling we have seen in other crises.
But this raises a second problem: does the presence of passive investors cause management to act in ways that increases the risk of an unravelling? Managers may be more insulated from volatile stock price movements, but passive investment funds are far from passive when it comes to the exercise of their voting rights. Funds like BlackRock invest passively but vote actively, often with management who through stock option based bonuses are now incentivised to deliver short-term shareholder value. According to a series of economic studies, these ‘passive-aggressive’ tendencies lead to higher dividend payments, an increase in CEO power through the appointment of fewer independent non-executive directors and lower capital expenditure. This strange post-crisis world of more voice but less exit pressure from capital markets may explain why managers have chosen to extend their empires through increasingly expensive inorganic expansion (it’s easier to pay a larger lump of dividends when combining two businesses) and seem keener to embrace the accounting innovations which allow the time-shifting of income and costs. But this is only storing up future problems; the combination of pricing softness on the liability side and the speculative character of goodwill (and other accounting items) on the asset side may well bring about the more volatile economic conditions which passive investment strategies have always struggled to adjust to.