Challenges posed by the rise of passive investing
THE swift rise of passive investing has been one of the more prominent features of capital markets over the past 20 years. Spectacular though the growth may have been, it has not come without hidden costs.
For example, if more people are investing in buy-and-hold instruments, has liquidity suffered and if so, what does this mean for market efficiency? Furthermore, what consequence does increasing passive ownership hold for corporate governance?
In June, Morningstar reported that the US has seen an enormous shift in the market away from active funds to passive investments in the past 20 years, mainly due to the “infamously-low success rate of active managers within the US equity field”, while in Europe, passive investing remains popular, with appetite for long-term funds growing.
“Research from Morningstar Direct’s European Asset Flows Commentary shows that long-term index funds posted inflows of 13.4 billion euros (S$19.2 billion) in April 2024, while actively managed funds experienced 1.9 billion euros in net outflows. Additionally, the market share of long-term index funds rose to 27.96 per cent as of April 2024, up from 24.79 per cent in April 2023’’.
Meanwhile, PwC has estimated that, by year-end 2025, total assets under management (AUM) that are passively managed will have grown to around US$36.6 trillion, representing about 25 per cent of global AUM.
Passive investing’s appeal lies in a simple argument: If the majority of active fund managers fail to beat their benchmarks consistently, then why not just simply buy and hold the benchmark in the first place?
Enter exchange-traded funds (ETFs), which for most cases, seek to simply replicate the performance of an underlying index.
However, one possible consequence is lower liquidity. The International Monetary Fund (IMF) Global Financial Stability Report suggested in October 2022: “The growing role of passive investing that offers daily redemptions to retail investors, coupled with signs of increased herding and concentration, has made market liquidity more vulnerable to rapid changes in sentiment...
“Moreover, the ability of arbitrageurs such as hedge funds to take advantage of temporary price dislocations in asset markets, and therefore act as liquidity providers, may be limited’’.
A second challenge is that if investors are more content to simply buy and hold, then reaction to price-sensitive news could be more subdued, making the market less efficient. This is a possibility that has been suggested by some, but not all, empirical research.
Third, according to the IMF: “Leveraged and inverse ETFs that rely on derivatives and short sales to amplify returns can introduce additional volatility in securities markets, because of the need to rebalance the leveraged positions at the end of the trading day’’.
Fourth is the question of whether passive owners who, as voting shareholders, are happy to go along with whatever is proposed by company bosses and rarely demand better performance.
For instance, some studies suggest that in firms with more passive investors, independent board turnover decreases so that directors serve longer terms.
One study also found more passive ownership affects corporate governance negatively and reduces shareholder value when it comes to high-cost governance activities, such as monitoring of mergers and acquisitions, and the choice of board members.
It is worth noting, however, that there is no real consensus on this point, as there are studies to indicate that passive managers do actively engage managements positively.
Still, although there are good reasons to welcome the rise of the ETF industry, investors should be aware that there could be downsides as well.
