Passive ETFs Distorting the Stock Market

New Academic Paper Adds to Evidence that Passive ETFs are Distorting the Stock Market

Continuing our recent coverage of passive ETFs distorting the stock market, a new academic paper by three German researchers convincingly argues that an increase in passive ownership is having a dramatic effect on the functioning of the stock market. Since cash flowing into ETFs (exchange-traded funds) causes indiscriminate buying in the underlying names represented by the fund, prices are becoming more distorted and market moves more extreme.

Philipp Höfler, Christian Schlag, and Maik Schmeling, from Goethe University Frankfurt, find in their new paper that increases in passive ETF ownership introduce noise into stock prices of the firms within the index. This also reduces the liquidity of the individual stocks and decreases the price efficiency of those companies, counter to the Efficient Market Hypothesis.

The researchers find evidence that as ownership of passive ETFs increase, the importance of a company’s fundamentals decreases. We at Passive Parabellum have documented this phenomenon extensively, and it should be obvious to market observers at this point. With hundreds of billions of dollars in annual cash inflows into passive funds, key financial metrics like firms’ sales growth, margins, profits, and cash flows matter much less if the key marginal buyer is an index fund that pays no attention to this data. The biggest factor in price appreciation, therefore, is the weighting that firm has in the index, with the lion’s share of the inflows being directed to market behemoths like the Magnificent 7.

 

 

Clearly passive ETFs are distorting the stock market. Add this to the pile of academic evidence these widely-adopted strategies are having a profound effect on market liquidity and causing valuations to inflate well beyond historical norms.

Amusingly, the Bloomberg article linked on the Tweet above contains the often-derided claim that passive investing is “worse than Marxism,” since at least under extreme central planning regimes there are (allegedly) intelligent individuals making decisions on how to allocate resources. Index funds, however, employ the world’s dumbest algorithm: Did you give me cash? Then buy. Did you ask for cash? Then sell.

As programmers are fond of saying: Garbage in, garbage out.

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