Q: Is the volume of money invested in ETF’s and passive investment strategies a cause for concern? With money leaving the market in recent weeks, will this exacerbate market falls?
A: On 31 August 2019, according to Morningstar Research, the value of funds that were invested to track US Equity indices exceeded the value of funds invested in active managed portfolios. The figure was an astounding $4.27 trillion US dollars. Since this tipping point the volume of passive money entering the market has continued to dominate fund flows at the cost of active managers.
The consequences for markets is profound. Where the market valuation of a company is determined more by the market capitalisation of the stock and its index weighting, than the underlying fundamentals of the company, enormous opportunities for mispricing of stocks can occur. This stock mispricing may be masked by the volume of passive money entering or leaving the market.
When passive money dominates new investment into the market in a rising market, shares that command a large index weighting continue to receive price support due to their index weighting rather than on the basis of their fundamentals and future prospects. When passive money leaves the market, the same effect occurs in reverse.
When money leaves the market and prices fall, passive investors with an index weighting bear the brunt of market exposure. During a bear market, active managers typically can demonstrate the value of their investment thesis provided they can “swim against the current” of funds outflow.
Generally speaking, in a falling market, active managers who invest in shares on the basis of a company’s fundamental qualities are more likely to outperform the broader market albeit at a higher management cost.
Passive Portfolio Management provides low-cost exposure to a particular market. However, the approach does come with additional market risks governed by both the momentum and flow of funds both into and out of the market. These additional factors need to be considered as part of any long-term strategy in both rising and falling markets.