Given the growth rates of recent years, it could hardly come as a surprise: At the end of 2023, the volumes of passive equity funds exceeded those of actively managed funds for the first time, at least in the US. In the current monthly question, the investment professionals of the German Association for Financial Analysis and Asset Management (DVFA) were therefore asked to state their assessment of this global development and its consequences.
Reasons for active management
The participants – without multiple answers – definitely see reasons against passive and in favour of active fund management, primarily due to the higher potential to beat the market in the long term (outperformance, 52%) or due to risk management (33%). This is because active managers can react more quickly and accurately to changing circumstances and data than index-linked funds. Especially in tighter, less efficient markets or when specific investment regulations have to be complied with.
Rather longer holding periods for passive funds
When asked about the holding period, 43% of participants assume that passive funds will be held for longer than active vehicles, but as many as 30% expect the opposite (“no difference”: 27%). In fact, the main factor here is the motivation of the investors. Institutional investors like to use ETFs for tactical allocation in order to be able to change certain exposures quickly.
Fears of negative liquidity effects
For more than 10 years, regulators such as the FSB, BIS and IMF have been focussing in particular on the liquidity effects of passive forms of investment, especially in times of crisis. Over 40% of DVFA investment professionals also expect negative consequences for market liquidity as a result of the global increase in passively managed assets. However, 32% expect positive effects and 28% do not see any impact. The triggered “herd effects” of passive funds as soon as buy and sell thresholds are exceeded are viewed with scepticism.
Increased correlation and concentration in individual securities expected
Consequently, questions were also asked about the effects on correlations and concentrations in individual securities. The result here was clear: two thirds (67%) of participants see increased correlations and, above all, concentrations as a result of the ever-increasing assets under passive management.
In your opinion, what effect does the increase in passively managed assets have on correlations and concentrations of individual securities?
Korrelationen = correlations
Konzentrationen = concentrations
Keinen Effekt = no effect
It became clear in the comments that many participants see this development primarily for dominant, “heavy” stocks in the index and less for the smaller stocks.
Higher market risk?
As a result, 59% see an increased overall risk, i.e. above all greater market volatility, especially during downturns. One third of investment professionals expect no or mutually offsetting effects. A certain tendency towards overvaluation could result from the constant demand for passively managed funds alone. Conversely, passive funds can significantly increase the well-known “revolving door effect” in times of crisis, for example in the event of negative news, sudden redemptions or portfolio reallocations. This is particularly true for index products focussing on special themes. When the Athens Stock Exchange was temporarily closed in mid-2015 during the Greek sovereign debt crisis, well-known investors such as Carl Icahn and Bill Gross vehemently warned of the consequences of ETFs, in particular of a “liquidity illusion” and the sudden drying up of the markets.
The participants are much more relaxed about a possible direct (generic) effect of passively managed assets on the attractiveness of IPOs. 59% do not recognise any effects here, while 28% expect rather negative consequences for IPOs and only 13% expect positive effects. This is interesting insofar as newly listed shares are generally not yet included in any index and are therefore excluded from index products. Small caps in particular could therefore tend to be at a disadvantage as assets are increasingly managed passively.
Increasing importance of fundamental analysis expected
If the correlations between individual stocks increase as a result of passive funds and products, fundamental analysis by investment banks, brokers and fund managers would become less important. This is the view of 23% of participants. Almost one in two (48%), on the other hand, expect market efficiency to decrease and fundamental analysis to become more important as a result. 29% of investment professionals see the importance remaining the same.
Cracks in the ecosystem?
“This is indeed an opportunity to reverse the trend,” says Ingo R. Mainert, Deputy Chairman of the DVFA Executive Board, in response to the last question. “The less money is actively managed, the more important it is to recognise and exploit information asymmetries in advance, especially for smaller and medium-sized assets. So there is no reason to write off the ‘human factor’ in asset management.”
“However, it was to be feared that a majority of investment professionals would associate the increase in passively managed funds with negative consequences – higher concentration and volatility,” comments Mainert on the survey. “This applies above all to difficult, crisis-ridden market situations, and if you take things to an extreme.” After all, if all investment money were to be invested in passive index products, there would no longer be any fact- and data-driven microeconomic pricing. Asset prices could only ever rise as a result of inflows. “But it doesn’t have to come to that,” continues Mainert, “because research, data analysis, human experience and forward-looking, active and impact-orientated fund management create added value – and are indispensable for a functioning market economy.”
His conclusion: “The term “passively managed product” is actually a contradiction in terms. Of course, these instruments are useful elements of the capital market, offer investors advantages in terms of costs through scaling effects and facilitate diversification. However, I do see a few cracks in the market ecosystem and also dangers for capital allocation due to the scale that has now been achieved. Several studies – including a recent one by Frankfurt’s Goethe University – suggest that prices of an asset class or an individual stock are more dependent on the weighting in an index due to the passive trend. Company-specific fundamental data and the resulting price signals tend to become less important. This is problematic for the economy and may ultimately even be detrimental to financial stability.”
Source: DVFA Press Release of 14 May 2024
