Passive Investing and the Markets | 5 Highlights from the SEC Investor Advisory Committee Meeting

Investors having increasingly turned to passively-managed funds as a tool for meeting their financial objectives. But what is the combined big picture impact of those individual decisions? In other words, how is the increasing use of passive management affecting the markets and the economy?

That’s the question that the SEC Investor Advisory Committee addressed during its afternoon session on September 13, 2018. Committee member and Harvard Law School professor John Coates chaired a panel discussion with speakers Jeb Doggett of Casey Quirk, Rodney Comegys of Vanguard, Robert Sharps of T. Rowe Price, New York University School of Law professor Marcel Kahan and MIT Sloan School lecturer Robert Pozen. 

“Funds focusing on active investing are key to the success passive funds, the SEC’s Investor Advisory Committee was told last week,” summarizes Ted Knutson, writing for Forbes. Read his recap of the meeting here. 

Here are our takeaways from the session:

Big change, big implications.

“Common sense would suggest that any shift of this magnitude will ultimately have consequences,” cautioned Robert Sharps.

And there’s no doubt that the movement of assets into passively-managed funds has occurred at a fast and furious pace. Jeb Doggett summarized the numbers: Today, $15.6 trillion of assets globally are passively -managed, having grown at roughly a 20% annualized rate– or 2½ times faster than the growth in traditional actively managed funds. Passively-managed funds now account for 23% of professionally-managed assets versus just 15% only 5 years ago. Put another way, 50% of organic growth in the fund industry has gone into passively-managed strategies.

It would be surprising if this massive shift didn’t have ripple effects. While those effects may be modest and manageable today, panelists’ predicted  that they will be more severe in a period of market stress. Panelists expressed particular concern about passively-managed funds investing in less liquid asset classes, where an ETF may be more liquid than its underlying securities.

Impact on market efficiency and capital formation.

The growth in passive investing may already be having an impact on the markets and the economy.

In line with many academic studies, T. Rowe Price has noticed an increase in correlations within the market and a decrease in price efficiency. These changes, which may be linked to the growth in ETFs, make it harder for investors to diversify effectively and increase the cost of trading.

For example, during the fall of 2015, pharmaceutical stocks were under considerable pressure as the debate about drug pricing intensified. However, other healthcare stocks with no risk exposure also sold off, apparently because they were included in the index that was the basis for a healthcare sector ETF.

The growth in passive management may also have changed daily trading patterns. Passively-managed funds often prefer to trade at the market close, so that their trades are completed at the end-of-day prices used to establish index values. Because of index funds’ increased demand, the costs of trading at the close have increased. At the same time, trading during the day has fallen off, which has led to heightened volatility.

However, the market impact of passively-managed fund trading is debated. Rodney Comegys argued that index funds account for only 5% of trading volume, meaning that market volatility is the result of broad political and economic trends, rather than index fund trading. Marcel Kahan suggested that increases in market efficiency may not increase economic efficiency, because of costs. He noted that it’s possible to overspend on the research and analysis that leads to market efficiency.

On the other hand, the growth of passive management may have real world effects that reach beyond the markets. Robert Pozen raised questions about index funds’ ability to support the IPO market.

Focus on corporate governance.

Perhaps the hottest topic at the afternoon session was the issue of proxy voting by passively-managed funds, a topic that has been much in the news.*

(*Proxy voting was the theme for the day. The Investor Advisory Committee’s morning sessions focused on proxy voting infrastructure. And earlier in the day, the SEC withdrew its guidance on proxy advisors, leading Commissioner Robert Jackson to open the afternoon session with a statement on shareholder voting.)

The consensus among the panelists was that index fund managers have invested heavily in governance and that they vote proxies responsibly. All fund managers, both active and passive, must pay attention to specific company issues as well as general governance policies, and they must communicate clearly with shareholders about their approach to ESG issues. However, Robert Pozen noted that active managers play an important role through company-specific research that informs proxy voting decisions.

The increasing concentration of ownership was another theme. As John Coates remarked, it will be a “different world” when the majority of votes at major corporations will be controlled by just a handful of firms, as will likely be the case in over the next 10-20 years.

Regulatory neutrality.

Another point of discussion was the stance that regulators should take in the active-passive debate. Several speakers and Committee members recommended that regulators remain neutral, not favoring one approach over the other, including in the selection of retirement default options.

SEC Chair Jay Clayton’s balanced remarks at the opening of the Committee’s deliberations seemed to anticipate this suggestion:

Finally, the schedule for the afternoon also includes a discussion of the growth of passive investing and its implications. Many say that passive investing provides a low-cost, low-maintenance way to obtain diversified investment exposure. A meaningful portion of market commentators also point to benefits of active management. Market analysts also posit that risk may be amplified as a result of concentration in passive strategies. And, there are the questions around how passive funds should approach engagement with companies on the one hand and engagement with their investors on the other hand. This issue also applies to funds that are actively managed and may dovetail with your proxy process discussions in the morning sessions.

Striking a balance.

The discussion at the end of the session focused on finding a balance between active and passive. Is there a market solution, or is there some friction that will prevent market forces from working?

Opinion was divided. Robert Pozen saw “no reason to believe that the market won’t reach equilibrium.” Robert Comegys suggested that fee reductions will eliminate a structural impediment to improved performance by active managers.

However, Robert Sharp and John Coates both expressed concern that there is considerable momentum behind the retail flows into passively-managed funds, given a “conventional wisdom” that favors index funds As long as the conventional wisdom holds sway, it will be difficult to reach equilibrium.

The Active Managers Council is working to challenge the conventional wisdom and bring a balance to the conversation about active and passive. Be sure to read the Council’s recent publication, “Challenging the Conventional Wisdom on Active Management: A Review of the Past 20 Years of Academic Literature on Actively Managed Mutual Funds,” [LINK] by professors Martijn Cremers, John Fulkerson and Tim Riley.