Are Passive Funds Milking the Investors?

Passive funds have become the cornerstone of modern investment portfolios, praised for their low costs and market-wide exposure. But is there more to the story than meets the eye? Could it be that these funds, while seemingly beneficial, are facilitating practices that ultimately disadvantage the very investors they aim to serve?

The Conflict of Market Making

Is market making a conflict of interest for passive fund managers? The role of market makers is to provide liquidity and ensure smooth trading, but are they capitalizing on inefficiencies and mispricing in passive markets instead? Given that perfect arbitrage is an impossibility, how much are market makers profiting from the spreads in passive markets? Top market makers are making over $30 billion a year. How is this revenue helping market integrity, reducing risk, and creating impact for investors? Could this significant profit be coming at the expense of investors, who are subsidizing these market makers?

Agency Conflicts

Are passive funds weak monitors compared to active funds? Unlike active funds, passive funds rarely vote against firm management on contentious corporate governance issues. Although passive funds exit 16% of their holdings each year, do they use this exit strategy to enforce good governance? There seems to be no evidence that passive funds engage with firm management. Could the rise of passive investing be shifting control from investors to corporate managers?

Poor Governance

Are investments in stewardship particularly costly for passive fund portfolio managers? Without the firm-specific information necessary to participate beneficially in governance, how can passive managers be expected to invest effectively in stewardship? Additionally, if passive fund managers capture only a small fraction of the gains from improved governance, do they have inadequate incentives to invest in beneficial stewardship? Could it be that passive fund managers are excessively deferential to management, who are often their clients?

Corporate Governance Impact

Corporate governance theories suggest that institutional investors can improve governance through intervention and the threat to exit. However, do passive institutional investors lack the ability to exit and the motivation to intervene, thus lowering the quality of governance in the firms they hold heavily? Empirical evidence suggests higher ownership by passive investors is related to lower firm value measured by Tobin’s Q and weaker operating performance measured by return on assets. How do passive investors exacerbate managerial myopia by discouraging long-term investment, weaken incentive schemes by lowering pay-for-performance sensitivity, and reduce board independence by raising the probability of CEO-chair duality?

Obligations and Fiduciary Duty

One area of ongoing focus for regulators is the role of authorized participants (APs) with regards to ETF liquidity, especially during periods of market stress. APs play a vital role in maintaining tight bid-ask spreads and ensuring ETFs trade as efficiently as possible. However, what happens if APs step away during market stress? There are concerns that without the AP arbitrage mechanism, ETFs could trade like closed-end funds, leading to significant discounts to their net asset values (NAVs). Given that APs are free to act within their own commercial interests and have no fiduciary duty to the ETF, what does this mean for investors during periods of extreme market stress?

Mispricing and Its Consequences

Do passive funds contribute to rampant mispricing in the market? These funds buy and sell securities to match an index without regard to price, potentially leading to transactions that don't reflect the securities' true value. This scenario seems ripe for market makers and high-frequency trading (HFT) firms to exploit. How often are HFT companies front-running orders placed by passive funds, executing trades based on advanced knowledge of pending transactions to profit from subsequent price movements? If front-running is prevalent, how much are investors unknowingly paying in higher prices due to artificial price inflation?

The Role of Dark Pools

What role do dark pools play in this dynamic? Designed to allow institutional investors to trade large volumes without affecting market prices, dark pools operate with limited transparency. Are HFT firms exploiting this opacity to gain insights into large trades and adjust their strategies? If so, how does this disadvantage retail and institutional investors who lack such information?

The Illusion of Liquidity

Is the liquidity offered by passive funds more of an illusion than a benefit? While intra-day liquidity might seem appealing, do most investors really need to trade their investments daily? Could it be that this emphasis on liquidity primarily benefits market makers and HFT firms by facilitating the churning of securities and boosting trading volumes? If the main advantage of liquidity is for these intermediaries, are investors being misled about the true benefits?

Systematic Risks and Market Distortions

Do the practices associated with passive funds contribute to broader market issues like concentration and herding? The massive inflows into passive funds often concentrate investments in a limited number of large-cap stocks, but what are the systemic risks of this concentration? Herding behavior, where many investors follow the same strategy, can amplify market movements and increase volatility. Is this creating a more fragile financial system, vulnerable to shocks from significant downturns in these few large players?

Ruining the stock markets

A new research paper by finance professors Hao Jiang, Dimitri Vayanos, and Lu Zheng argues that the rising popularity of index funds is contributing to the overconcentration of the stock market into a few megacap stocks like Apple, Nvidia, and Microsoft. This trend is exacerbated by many active funds becoming closet indexers, closely shadowing the indexes they are supposed to outperform. As a result, the largest firms receive disproportionate investment inflows, inflating their stock prices and creating a feedback loop that attracts even more investment. This dynamic makes the S&P 500 more of a short-term trading game rather than a long-term investment strategy, leading to potential market distortions and increased systemic risk.

Bibliography

Arends, Brett. "Index funds are ruining the stock market." Dow Jones, June 15, 2024, 8:56 AM.

Heath, D., and Ringgenberg, Matthew C. "Agency Conflicts and the Rise of Passive Investing." 2019.

Jiang, Hao, Vayanos, Dimitri, and Zheng, Lu. "The Impact of Passive Investing on Market Concentration." 2024.

Lund, D. S. "Passive Investing and Corporate Governance: A Law and Economics Analysis." 2020.

Qin, Nan, and Wang, Di. "Are Passive Investors a Challenge to Corporate Governance?" 2018.

ETF Stream. "The Role of Authorized Participants in ETF Liquidity and Their Fiduciary Duties." Webinar, 2024.

Zeng, Yao. "Conflicts of Interest in ETF Arbitrage and Market Making." University of Washington, 2024.

Pal, M. "Are Index Funds Herding Mechanisms", Money Control, 2024