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Passive investing strategies are becoming a victim of their own success. In the process, they are shaking the foundations on which they were built, distorting markets and introducing unintended risks.

The risks are acute: Markets are now comprise the highest proportion of passively managed assets than ever before and, in periods of high market volatility, the distortive effects are more pronounced.

Low-cost market tracking, diversification and reduced volatility are key pillars of passive strategies that underlie index and exchange-traded-fund (ETF) investing.

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Yet the explosive growth in passive investing has begun to undermine the very characteristics that are perceived to be their most important advantages compared with active investment management.

Passive funds are no longer market bystanders, but important influencers that transact daily in ever-growing amounts.

Index funds and ETFs are governed by simple rules: When the funds attract inflows from investors, they buy the underlying securities in the particular index or group; when they experience outflows, they sell them.

These funds hold virtually no cash, exercise no discretion nor perform any fundamental analysis. They are, in and of themselves, devoid of any sensitivity to the valuation or fundamentals of markets and the securities that underlie them.

For passive strategies to deliver their purported benefits, they are implicitly reliant on active market participants to perform two critical functions.

One is to act as an adjudicator of valuation through their collective decision-making as reflected by share prices. In essence, the efficient market hypothesis (that share prices reflect all information) is at the core of all passive strategies.

The second is to provide the liquidity necessary to enable the passive funds to buy or sell the underlying securities as dictated by their inflows and outflows.

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For example, Microsoft Corp. is estimated to be a component in a staggering 145 ETFs. If fund inflows require that passive funds buy Microsoft shares, active managers are an important source of the supply necessary to meet that demand. But assuming the current price of Microsoft already reflects the aggregate wisdom of all market participants, this new demand will drive its price and valuation unjustifiably higher.

While seemingly innocuous, the reverse situation also occurs. If active managers’ purchasing power cannot offset the supply from passive fund outflows, stocks will continue to fall, often with devastating effects.

As passive funds become the dominant investment vehicles in the markets, they crowd out actively managed funds and distort the value of the markets they are designed to track. The larger ETFs grow as a percentage of the overall market, the greater this distortion.

The growth in passive funds has another consequence – increased correlation. Stocks that underlie passive investments are bought and sold in a basket; they become welded together. This alone undermines the diversification benefits of ETF investing.

Additionally, as certain stocks become ever-larger components of various indexes and ETFs (the so-called FAMGA stocks, for example – Facebook, Apple, Microsoft, Alphabet subsidiary Google and Amazon.com) individual security concentration reduces diversification even further.

Higher correlation results in higher volatility, affecting market performance. Reacting more than ever to passive fund flows, markets tend to overshoot on both the upside and downside. The liquidity that would typically be provided by active managers, especially as valuations trend toward extremes, is overwhelmed by the passive flows.

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The cumulative distortive effects on markets is particularly evident in severe drawdowns like the one we recently experienced. Passive funds facing outflows are forced to indiscriminately sell the underlying components of the index fund or ETF, irrespective of industry sector or fundamentals.

There is no question that ETF index investing has distortive effects on the market. Stocks often see a valuation uptick of 10 per cent or more when they are added to an index because, once included, a number of passive funds must own them. Understandably, investment bankers often pitch index/ETF inclusion as a reason for companies to grow by merger or acquisition. Larger representation in any index/ETF will result in higher valuation versus comparable companies that are not included. Similarly, stocks that get removed from an index/ETF for whatever reason, will fall substantially as passive funds liquidate their holdings.

Active management may again have its day, albeit in a new and improved iteration.

Passive strategies are reliant on active participants to function as intended and, in times of increased uncertainty, investors may find it worthwhile to entrust their assets to those who perform real fundamental analysis.

To quote John Bogle, the father of passive investing and founder of Vanguard, “If everybody indexed, the only word you could use is chaos, catastrophe …. The markets would fail.”

Jeffrey White is founder and CEO of Hinge Markets Inc., a capital markets advisory firm

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