The Impact of Passive Investing on Market Efficiency

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Academic studies are beginning to shed light on how passive ETFs are influencing markets.

These studies suggest that:

  • Valuations for individual stocks are influenced by inclusion in indexes.
  • The volume of “informationless” ETF trading is raising trading costs for individual stocks and making the pricing of stocks less efficient.
  • As ETF ownership of a stock increases, it begins to move more in line with its sector and with the overall market, and less in line with its own earnings.
  • Rising correlations will degrade the benefits of diversification.
  • A focus on company fundamentals, especially free cash flow, combined with a long-term time horizon can mitigate distortions being introduced by passive trading.

Is the Rise of Passive Investing Making Stock Markets Less Efficient?

Let’s back up for a moment, and explain why we are asking this question. We first addressed the issue of active versus passive management in two white papers we wrote in 2015. Those papers discussed the flaws in the theoretical case for passive management, and laid out a case for what an active manager must do to outperform an index. One point we did not make in our earlier papers, but which we did highlight in our 2016 book, “Winning at Active Management,” is that neither a world of 100% active management nor a world of 100% passive management would represent an equilibrium outcome.

In a world where everyone was an active manager, stock markets would tend to be very efficient, as prices would incorporate the varied insights of many different managers, each reacting to any deviation between a given stock’s price and its perceived value by buying or selling. Even though different investors would have different perceptions of that value, based on the different pieces of information that each had uncovered, their combined buying and selling would tend to ensure that the price reflected all of the relevant information. That would mean that opportunities to outperform would diminish. This would be a perfect environment in which to switch to passive investing. Since everyone else would be engaged in fundamental research, the benefit to the marginal investor of doing any additional research would be minimal; the market has probably already priced in any information you would find. You could essentially “free ride” on the research efforts of others by simply buying a passively managed index fund, confident that prices are fully incorporating any information that matters.

At the other extreme, in a world where everyone invested in passively managed funds, nobody would be doing any fundamental research. Stock prices would diverge from any semblance of fair value, simply because nobody would be making any effort to figure out what that fair value might be. All trading would be “informationless,” i.e., not driven by any opinion on what a stock was worth, but rather driven simply by cash flows in or out of the market for whatever reason (e.g., someone needs to sell some stock in order to buy a house). In such a world, there would be a tremendous incentive to switch to active management, because even a small amount of fundamental research would likely reveal enough mispricing to enable a portfolio manager to more than earn back the cost of doing that research through outperformance. (Although this does raise an interesting logical dilemma: what if there was only one active manager? For prices to move toward their fair value, markets require more than just one investor who is trading based on an opinion of what that fair value is. The benefit of having skill depends upon the existence of other active investors who eventually come to agree with your point of view on what a stock is worth, and who then bid the price up — or down — to that level. We will return to this question later.)

So, neither a world of all active nor a world of all passive would be likely to stay that way for long — it would seem that we are destined to see a world in which there is a mix of active and passive management. Of course, since we started with a world that was essentially all active (in the days before technology made indexing feasible), we have tended to move in one direction, with the level of passive investing rising steadily, as we seek that equilibrium somewhere in the middle. But this leads to a question. Clearly, a market of 100% passive management would be inefficient, but it does not seem realistic to believe that the level of inefficiency would remain at zero (i.e., all stocks are priced to reflect all available information) until the last investor switched to passive. Rather, it seems more likely that as the number of active managers began to dwindle, prices would, at some point, begin to stop reflecting some relevant information, simply because there would begin to be some information that nobody had bothered to discover. At the same time, the increasing level of trading being done by investors who are, in effect, indifferent to price (i.e., passive investors) would presumably start to have an impact on the way that stocks trade. So, the real question is, at what level of passive management would inefficiency in pricing start to creep in? That is the topic we address in this paper. Recent academic research suggests that passive management is already affecting the pricing efficiency of the stock market, and in some perhaps unexpected ways.

The information contained in this white paper is distributed for informational purposes only and should not be considered investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. The information contained in this white paper is accurate as of the date submitted, but is subject to change. Any performance information referenced in this white paper represents past performance and is not indicative of future returns. Any projections, targets, or estimates in this white paper are forward looking statements and are based on Epoch’s research, analysis, and assumptions made by Epoch. There can be no assurances that such projections, targets, or estimates will occur and the actual results may be materially different. Other events which were not taken into account in formulating such projections, targets, or estimates may occur and may significantly affect the returns or performance of any accounts and/or funds managed by Epoch. To the extent this white paper contains information about specific companies or securities including whether they are profitable or not, they are being provided as a means of illustrating our investment thesis. Past references to specific companies or securities are not a complete list of securities selected for clients and not all securities selected for clients in the past year were profitable.

Active management is an investment strategy involving ongoing buying and selling actions by the manager. Active managers purchase investments and continuously monitor their activity in order to exploit profitable conditions.

Active management typically charges higher fees than passive management.

New York Life Investment Management LLC engages the services of Epoch Investment Partners, Inc., an unaffiliated, federally registered investment advisor. MainStay Investments® is a registered service mark and name under which New York Life Investment Management LLC does business. MainStay Investments, an indirect subsidiary of New York Life Insurance Company, New York, NY 10010, provides investment advisory products and services. Securities are distributed by NYLIFE Distributors LLC, 30 Hudson Street, Jersey City, NJ 07302, a wholly owned subsidiary of New York Life Insurance Company. NYLIFE Distributors LLC is a Member FINRA/SIPC.

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Epoch Investment Partners, Inc.

Epoch’s investment approach is designed to uncover opportunities that others may miss. In our view, growth of free cash flow, and the intelligent use of that cash flow, represent the best predictor of long-term shareholder return. We look for strong company management with

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