It’s the latest critique of the passive-investing boom: Fresh academic research claims that the relentless flood of index-chasing cash on Wall Street is distorting stock prices and causing extreme market moves.
With assets in such exchange-traded funds now above $7.1 trillion in the U.S. alone, a team from Goethe University in Frankfurt has published a paper arguing the frenzy is disrupting the natural investing order by spurring equity gyrations and blunting the role of company earnings on market prices, among other charges.
In so doing, the study adds fuel to familiar gripes about an allocation approach that’s been dubbed “worse than Marxism” and named a chief suspect in bubble-like valuations in U.S. mega-cap stocks.
Industry champions strongly reject such claims, and the Goethe team acknowledges that the current literature is inconclusive. So they determined to find out how passive ETF ownership affects things like liquidity and the likelihood of extreme price moves.
Using a sample that included 872 passive ETFs, all common U.S. stocks, and ownership and return data spanning more than 20 years through to the end of 2021, the researchers concluded that higher passive ownership increases a stock’s bid-ask spread, its volatility and its sensitivity to broader market liquidity.
Then, by analyzing the variation in passive ETF ownership caused by index inclusions or removals, they also found increased passive ownership was associated with a greater risk of extreme price moves.
“We further show that more passive ownership increases the exposure of stocks to market-wide sentiment shocks,” Maik Schmeling, Philipp Hofler and Christian Schlag wrote in the paper. “Our results suggest that the decrease in liquidity that comes with more passive ETF ownership stems from an increase in short-term noise trading, which decreases the importance of firm-specific news.”
In the study, noise refers to non-fundamental information, like a temporary buying frenzy or false news. Firm-specific information refers to new trading intel like earnings, product launches, or sophisticated analysis. The researchers found that a one standard deviation increase in passive ETF ownership of a stock raised the impact of market noise by about 6 percentage points, and decreased that of firm-specific information by 9 percentage points.
“Passive ETFs are said to attract short-term, uninformed investors, because these funds offer low fees, low transaction costs, simplicity, and the ability to buy and sell shares quickly,” said Schmeling, a finance professor at Goethe. “Furthermore, uninformed investors tend to trade on non-fundamental information (i.e., they trade around a lot based on twitter rumors, chart signals, tips from online influencers, etc). As a consequence, passive funds also have to buy and sell the stocks they hold, passing on the ‘noise’ to the underlying stocks.”
Plenty of ETF proponents would debate these sweeping conclusions. As the largest owner of ETFs, BlackRock Inc. has long faced criticism that passive investing exacerbates market crashes because index-hugging investors crowd into a handful of stocks. Chief Executive Officer Larry Fink hit back in a June interview, stating that ETFs enhance price discovery and arguing the critique that passive investing accelerates volatility has been “debunked.”
