Passive ETF Flows are driving stock market returns

Russell 2000 Index Returns Driven By Passive ETF Flows

Adding to the copious evidence that passive ETF flows and index fund flows are distorting the market, Tier1 Alpha recently noted the stark contrast between the performance of the Russel 2000 index before and after the creation of the Russel 2000 ETF, ticker IWM.

 

The inception date of the iShares Russell 2000 ETF was May 22, 2000.


As you can see from the chart,  the volatility of the index was much more subdued before passive inflows from the Russel ETF became the dominant factor directing investment flows. The tail wagging the dog of the index, so to speak. As you can see from the chart, the effect is like night and day in terms of the volatility of the small cap index.

Before the year 2000, 2% moves in a quarter for the index were virtually non-existent. Afterwards, they were extremely prevalent, especially around market turning points.

Why is this? Because index funds and ETFs have almost exclusively been net buyers of stocks in the major indices like the S&P 500 and the small-cap focused Russell 2000. They buy every stock in the index. Since passive strategies have been steadily gaining share for decades, the shares they buy are locked away in the passive indexing vault, never to be seen again (at least until index funds have outflows).

As indexing strategies are now approaching about half of the U.S. stock market, passive investing theory predicts that volatility would pick up dramatically, since there are fewer active sellers to hand their shares over to the primary buyers — index funds.

Sure enough, the move off the lows of October 2023 into the end of the year was historic, as Tier1 Alpha notes in their tweet, rising 23% in just 6 weeks. Based on the historical data this outcome is in the 99.5% percentile of market moves.

As passive continues to gobble up all available shares in the market, this suggests we will be setting more volatility records on the upside and the downside. When large inflows to passive occur, there are fewer and fewer active hands to sell shares. Remember, passive funds can only buy from active players at present, since no passive funds are selling. As active management shrinks, this source of supply is steadily dwindling, leading to bigger moves and greater volatility.

This will not end well.

 

 

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