Alternative index strategies have captured significant inflows as passive investors sought different ways to taking exposure to the market but this could bring with it significant risks, according to one investment strategist.
Recent years have witnessed the rise of alternative approaches to passive index investing and there are now over 700 exchange-traded funds (ETFs) tracking indices with a sector bias or a methodology driven by some fixed rule other than simple market capitalisation, figures from Schroders show.
Sean Markowicz, research and analytics strategist at Schroders, added that these alternative equity index ETFs – which include sector, smart beta and thematic strategies – are more popular than traditional broad market capitalisation-weighted ETFs.
Over the past five years, around $6 in every $10 that has flowed into US equity ETFs has gone to alternative equity index strategies; this has taken alternatives’ share of assets to 64 per cent of the total US equity ETF market.
Investors have preferred to invest in alternative index strategies
Source: Schroders, Bloomberg. As at 6 Dec 2018
Smart beta ETFs (which aim to outperform the market or enhance a portfolio in ways such as reducing volatility by systematically selecting holdings on the basis of fundamental characteristics like valuation or company size) have been the most popular. In 2018, their assets under management reached a record $1trn.
However, Markowicz pointed out that there are some fears about how the growing presence of alternative index ETFs could be distorting markets and creating potential problems for the future – such as heavier market shocks.
“Active investors buy and sell stocks based on their evaluations of company prospects and in doing so contribute a service to the market by allocating capital accordingly. Since passive investors have little interest in the idiosyncratic attributes of companies, they, in effect, freeride on the efforts of active investors,” he said.
“There is nothing wrong about this. Since a broad market index reflects the allocation of capital by active investors, passive flows into and out of that index will not change that. However, if there are sufficient passive flows into a segment of that index, then passive flows can cause prices to deviate from where they would otherwise be.”
The strategist said it is easy to see how this happens. Segmenting a broad market index by sector, company size or fundamental attributes means a smaller universe of securities is being captured and their weightings must deviate from their market cap weights in the broad index.
An unforeseen consequence of this is indiscriminate buying and selling of stocks based solely on the more targeted index composition rather than their individual company fundamentals, which can sometimes cause broad-based market moves.
Markowicz compared the aggregate weight of Apple in all ETFs to its market cap weight in a broad market index in order to show the price pressures created by passive flows. Apple has a market cap weight of 2.8 per cent in the CRSP US Total Market index (which represents nearly 100 per cent of the investable US equity market).
This compares with a weight of between 5 and 19 per cent in the various technology sector ETFs, 8.5 per cent in the Vanguard Growth ETF, 5.2 per cent in the Victoryshares US Min Vol ETF, 4.8 per cent in the iShares Edge MSCI USA Momentum ETF and 3.8 per cent in the Fidelity Value Factor ETF.
The 10 largest US stocks have received disproportionate inflows relative to their market cap
Source: Schroders, Bloomberg. As at 6 Dec 2018
“The net result of this is that, while Apple has a market cap weight of 2.8 per cent, the aggregate weight of all the ETFs in which Apple is listed is 4.8 per cent,” Markowicz noted.
“So, for every $1 of net flow into these ETFs, Apple receives 1.7x (4.8 divided by 2.8) of its market-cap-based weight of flow. In the last 12 months, cumulative net flows into Apple have been approximately 1.5x its current market cap weight.”
Of course, the risk here is that any reversal of flows – which the strategist said is “inevitable at some stage” – will result in these stocks being sold in greater proportions.
Some evidence of this might have been seen last year. Markets had their worst Christmas Eve trading session in history in 2018, with the S&P 500 falling 2.7 per cent. During this time, investors pulled $3.8bn from alternative index ETFs, which was a 1.5 standard deviation from average daily flows.
“Although it is difficult to estimate the exact market impact of this flow activity, we believe that based on its magnitude and previous academic research, it exerted some downward pressure on stock prices on the day,” Markowicz said.
But the strategist pointed out that the above is only a systematic risk if ETF investors ‘rush for the exit’ at the same time and should never materialise if they are long-term investors.
There are indeed some reasons to expect index-tracking investors to behave in a stable way. For example, many smart beta ETFs are seen as long-term holdings as they capture investment factors that are meant to outperform the market over the long term.
Meanwhile, they tend to attract ‘buy and hold’ investors looking to minimise trading costs while passive investors may be less concerned by relative performance.
However, it also has been kept in mind that the intraday trading flexibility could encourage short-termism and less stable investment behaviour.
Research on times of market stress by the Bank for International Settlements found both broad market and alternative ETFs exhibited the largest fund flow volatility relative to their assets size, compared with index mutual funds and active mutual funds. This suggests to Markowicz that ETF investors do ‘rush for the exit’ in market corrections.
“ETFs have democratised alternative approaches to passive equity investing. However, the shift in investor preference for alternative index strategies over broad market strategies may be storing up trouble,” the strategist concluded.
“This combination of strong demand for alternative equity index ETFs, over-buying of certain stocks and a tendency of ETF investors to buy and sell at the wrong times, is a worry.
“If the tide of money suddenly reverses, then stocks that were disproportionately bought will be disproportionately sold, worsening a market drawdown.”