Passive Bubbles?

July 2017

Amid the deluge of discussion about the rise of passive investing, two striking conjectures about its effects have emerged in practitioner literature and the media: passive investing is 1) causing stocks in major benchmarks to trade at a premium to the rest of the market,1 and 2) feeding an equity bubble that threatens perhaps “catastrophic” consequences.2
 
These claims, if true, would have important implications for investors. They would suggest that cap weighted “beta,” embedded in all kinds of strategies, is overpriced. They might portend a market crash. They might suggest that the trend towards passive has become overextended with little room left to run. 

While we see good reason to believe that the evolution of index-linked investing may gradually influence market behavior, 3 we haven’t (yet) found indications that passive is responsible for an index valuation premium or an equity market bubble. In this note, we examine evidence from three modes of analysis, and we discuss what the negative results might tell us about the rise of passive itself—its nature, actual market penetration, and prognosis. 

Evidence

Over the past several years, investors have withdrawn hundreds of billions of dollars from U.S. active equity funds in sharp contrast to their steady net contributions into passive. (Figure 1a) At the same time that the disparity between active and passive fund flows has grown increasingly conspicuous, U.S. stocks have enjoyed a substantial but, as some have described it, unenthusiastic, bull market. Valuations, as measured by the S&P 500 Cyclically Adjusted PE ratio (CAPE), have risen into their historical top decile, exceeding pre-GFC levels (Figure 1b).
 
In searching for explanations of the market’s strength, some industry, academic, and media observers have speculated about connections to the rise of passive. Specifically, that demand for benchmark-tracking strategies may be 1) inducing a valuation premium in those indexes’ component stocks, and/or 2) feeding an equity-wide bubble. 

Is there evidence to support such claims? We consider three tests.

Figure 1A

Figure 1A

 *Here, passive includes index funds and ETFs. Active consists of actively managed mutual funds. For illustrative purposes only. Source: Investment Company Institute. 2017 Investment Company Fact Book: A Review of Trends and Activities in the Investment Company Industry. Washington, DC: Investment Company Institute.

Figure 1B

Figure 1B

* Through Feb, 2017. Real price of S&P Composite Stock Price Index divided by 10-year trailing average real S&P Composite earnings. Source: Yale University Department of Economics. Online Data Robert Shiller. Index Source: Copyright © 2017, Standard & Poor’s Financial Services LLC. All rights reserved. For illustrative purposes only. It is not possible to invest directly in any index.

#1: Index Inclusion Effects 

If demand from benchmark tracking funds induces an index valuation premium, then we might expect that the announcement of a stock’s addition to an index would cause its price to rise and remain elevated.4 The S&P 500 seems a natural place to look for such a pattern. Over $2 trillion in assets are indexed to it,5 and it accounts for about 1/3 of all U.S.-based index mutual fund AUM.6 

Figure 2 shows that on average over the past 35 years, prices of S&P 500 inclusions do, in fact, rise upon the announcement (blue trace), which, for most of this period, occurred roughly five trading days prior to the inclusion event itself.7 Traditionally, this pattern has been attributed to 1) short-term market impact associated with indexers’ forced trading on or very close to the addition date and/or 2) a permanent valuation premium associated with indexation. Figure 2 shows some erosion of the cumulative excess return within two weeks following the actual event, suggesting that short-term effects play a role. 

Of particular relevance to this discussion, though, a comparison of recent index additions (grey trace) to the overall sample seems to offer no evidence that growth of passive funds is exacerbating effects. Cumulative pre-inclusion excess returns have been substantially smaller in recent years than the full sample average. As well, a material fraction of the premium still quickly erodes, further diminishing the evidence that passive is generating a long-term valuation premium.

This isn’t a clean test for several reasons, however. For example, in 2004-2005 S&P applied a free-float adjustment to the index, which reduced the likelihood that tracking strategies would bid-up a relatively small quantity of publicly floated shares to obtain a holding consistent with a stock’s full market capitalization. As well, program trading technologies, awareness of index reconstitution effects, and other aspects of market structure have evolved considerably since the early 2000s, and market volatility and liquidity have varied over time.8 Despite such caveats, Figure 2 doesn’t seem to provide evidence of a growing long-term valuation premium associable with growth of passive funds (nor did closer inspection of the year-by-year time series behind it).

Figure 2

Figure 2

*Average cumulative (sum) returns in excess of Value-Weighted Market Index (not beta adjusted) 20 trading days prior through 15 trading days after addition to S&P 500. Only the first addition to the S&P 500 is included for securities added on multiple occasions. Securities without trade data 20 days prior to addition are removed. Sources: CRSP®, Center for Research in Security Prices. Graduate School of Business, The University of Chicago. All rights reserved. crsp.uchicago.edu. Ken French Data Library (Value-Weighted Market Index), Copyright 2017 Kenneth R. French. Index Source: Copyright © 2017, Standard & Poor’s Financial Services LLC. All rights reserved. Acadian estimates and calculations. 
For illustrative purposes only. This is not intended to represent investment returns generated by an actual portfolio. They do not represent actual trading or an actual account, but were achieved by means of using the S&P constituents for the period specified above. Results do not reflect transaction costs or other implementation costs. Past results are not indicative of future results. Every investment program has an opportunity for loss as well as profits.

#2: Index Valuation Premium 

As a second test, we directly examine whether valuations of stocks in the S&P 500 are systematically elevated relative to the rest of the market. Figure 3 shows results from a regression-based analysis estimating the year-by-year impact of S&P 500 membership on a stock’s P/E ratio controlling for industry group and beta. The chart suggests that, if anything, S&P 500 membership is associated with a lower P/E ratio, and it provides no evidence of a trend towards increasing valuation pressure as the percentage of passive fund assets has grown.

This is a tricky analysis, however. The effect we are testing for is difficult to distinguish from other factors that might be associated with valuation, especially market capitalization, which is highly correlated with S&P 500 membership.9 But a variety of other specifications not reported here, including restrictions on market capitalization, alternate treatments of outliers, as well as inclusion of growth and momentum factors, provided no further evidence of an S&P 500 index premium.

Figure 3

Figure 3

*Regression coefficient estimated in cross-section of U.S. common stocks with market capitalization > $100MM and stock price >= $2. Excludes banks, diversified financials, real estate (GICS codes 4010, 4020, 4040, 6010). P/E ratios trimmed at +/-5%. Regression includes controls for 4 digit GICS code and beta (trailing 1-year). Sources: Acadian, CRSP®, Center for Research in Security Prices, Graduate School of Business, The University of Chicago. All rights reserved. crsp.uchicago.edu. Index Source: Copyright © 2017, Standard & Poor’s Financial Services LLC. All rights reserved. For illustrative purposes only. This is not intended to represent investment returns generated by an actual portfolio. They do not represent actual trading or an actual account, but were achieved by means of using the S&P constituents for the period specified above. Results do not reflect transaction costs or other implementation costs. Past performance is no guarantee of future results. Investors have the opportunity for losses as well as profits.

#3: Passive Ownership Valuation Premium
 
The first two analyses test for a relative valuation premium in the S&P 500, but that focus might no longer be ideal given a weakening of passive fund ownership’s association with market capitalization over time, which presumably reflects growth in assets tracking mid-and small-cap indices as well as the proliferation of other products classified as passive (e.g., style and sector vehicles). 

So as a third approach, instead of testing for an S&P 500 premium, we directly analyze the relationship between passive fund ownership levels and valuations in the cross section of equities. Figure 4 shows the key result, charting average “Price to Intrinsic Income Value” scores, an Acadian peer-adjusted, earnings-related valuation measure, in the highest and lowest deciles of fund passive ownership (here scaled so that a lower value indicates relative cheapness, consistent with a raw P/E). Once again, passive ownership doesn’t seem associated with higher valuations, nor do we see an apparent trend towards increasing valuation pressure among stocks with high passive fund ownership.

Figure 4

Figure 4

*Ownership data from Thomson Reuters Ownership Database using classification “Passive” and “Mutual Fund.” Price to Intrinsic Income Value Score is an Acadian developed proprietary measure of value based on various income measures, which we have scaled here (by -1) so that lower values imply relative cheapness. Data is restricted to U.S. common stocks with market capitalization > $100MM and stock price >= $2. 
For illustrative purposes only. Hypothetical results are not indicative of future results. There can be no assurance that any forecast will be achieved. This is not intended to represent investment returns generated by an actual portfolio. They do not represent actual trading or an actual account, but were achieved by means of using Thomson Reuters Ownership Database for time period and restrictions specified above. Results do not reflect transaction costs or other implementation costs. Past performance is no guarantee of future results. Investors have the opportunity for losses as well as profits.

Candidate Explanations For Negative Results 

What might we infer from the results of these three analyses? It may be that the hypothesized valuation pressures actually exist but that the tests we’ve used here simply aren’t powerful enough to discern them or that we’ve omitted control variables that would have helped to reveal the link; it is challenging to prove a negative. But we’ll leave such methodological refinements to future research and instead consider what three other candidate explanations might suggest about “the rise of passive” as well as equity valuations. 

#1: No Index Premium: Passive Hasn’t Gotten Far Enough (Yet) 


Despite headlines about eye-catching fund flows, passive simply may not yet have reached a point where it would induce a material index premium. Loosely speaking, we might expect a valuation premium associated with passive if, compared to long-only active, passive flows are material in size and less valuation sensitive, and if arbitrageurs face constraints, e.g., limitations on shorting, that prevent them from completely driving out fundamental mispricings. The lack of evidence for index and passive valuation premia suggests that at least one necessary condition is missing. 

It is beyond the scope of this note to estimate a “saturation level” for passive investing, if one exists. But passive’s penetration, while significant, hardly seems dominant. About 37% of U.S. domiciled equity fund AUM was passively managed as of Q1 2017 (Figure 5), perhaps in the neighborhood of 45% in purely domestic strategies, and active fund AUM remains near an all-time high in dollar terms. As well, the trend in passive fund assets may partially reflect movement of institutional passive portfolios from more opaque to more transparent vehicles (e.g., SMAs to funds).

Figure 5

Figure 5

*Through Q1 2017. Source: BofAML Global Research. For illustrative purposes only.

#2: No Relative Index Premium; It Is Equity Market-Wide 

As we noted at the outset, one notion in circulation is that passive is feeding an equity market bubble. Our original three analyses don’t actually test this hypothesis. Instead they test for relative valuation pressures within the cross-section of equities. If there were a premium associated with benchmark inclusion or high passive ownership, it is plausible that long-only active investors might respond by bidding up the rest of the market, i.e., stocks outside the major benchmarks or with low passive ownership, seeing it as cheap by comparison. In that case, relative valuation tests would come up negative because valuation pressures have been spread to the entire market, i.e., an equity market bubble. 

So do we see compelling evidence of a passively induced market wide equity bubble? Looking at valuations, while the CAPE may have reached levels last seen in connection with the internet bubble, fixed-income yields—representing the obvious alternative to holding stocks—have often been higher when earnings yields have been similarly low. Figure 6 shows, in fact, that after adjusting for rates, U.S. earnings yields don’t look unusual.10 (We’d reach a similar inference normalizing for real rather than nominal yields.) And while it might be the case that all financial assets have become expensive, including fixed income, it’s not obvious that such a pattern would be attributable to passive investing as opposed to other causes, such as policy-driven asset price inflation or demographic trends.

Figure 6

Figure 6

*Through Q1 2017. Float-adjusted capitalization weighted average of earnings yields (12M trailing) for stocks in the MSCI USA index. Source of P/E data: Acadian. Source of index composition data, MSCI. Copyright MSCI 2017. All rights reserved. For illustrative purposes only. It is not possible to invest directly in any index. Every investment program has the opportunity for losses as well as profits. Past performance is no guarantee of future results.

#3: There Are Bubbles— But “Thematic,” Not “Pure Passive” 

In trying to discern passive’s impact on markets, semantics are muddying the waters. Products that are widely classified as passive may facilitate active strategies or embed active characteristics, a conflation of “passive” with “thematic.” As evidence, in Figure 1a, index-linked ETFs, whose convenience, cost, and liquidity, make them ideal candidates to implement many active strategies, account for the lion’s share of the passive fund inflows, as compared to traditional mutual funds.11 Attesting to the relevance of their tradability, ETFs now account for roughly 1/3 of U.S. equity market volume. As well, ETF products continue to proliferate. There are over 1,600 listed in the U.S. alone, including roughly 600 that represent pure U.S. equity strategies, slicing the market in disparate ways. And although index-based, ETFs may represent narrow universes and reflect a variety of other active characteristics such as alternative weighting schemes, dynamic allocations, and turnover constraints. 

The conflation of “pure passive” (which we might describe as set-and-forget allocations to broad cap-weighted indices) with “thematic” (any other kind of index-linked investing) raises further questions about “pure passive’s” market penetration and whether we should expect that flows labeled as passive might be creating enduring valuation premia associated with broad market benchmarks. It also suggests, however, that we should not dismiss the possibility that the maturation of index-linked investing might be creating short-term and/or narrow-based valuation pressures. 

Conclusion 

While the analysis presented in this note isn’t exhaustive, it does not offer evidence that passive has induced a long-term index valuation premium or that it is feeding an equity market bubble. Investors should be wary of hype regarding passive’s impact on valuations, and we should set a high evidentiary bar for such claims. But the negative results here don’t preclude other effects on markets, in particular, arising from the evolution of index-linked “thematic” investing, which is being conflated with “pure passive.” These might include changes in comovement patterns, pricing efficiency, and market fragility, as we’ve discussed in prior work. The conflation of passive with thematic also highlights that investors should look beyond labels, and carefully scrutinize the active behaviors and characteristics associated with a strategy regardless of how it is labeled or classified.

Endnotes

1 “But the rapid rate at which money continues to flow out of active funds and into passive ones prognosticates an asset bubble. From a pure valuation standpoint stocks trading in index funds tend to be overvalued compared to those not in index like funds.” Trevir Nath, NASDAQ, February 8, 2017. 
2 “Short term asset price declines have been reversed by the wall of money coming out of active investment managers… and into the accounts of low-cost index products... But this comes at the expense of making the eventual decline in a broad range of asset values not just painful, but catastrophic.” John Dizard, Financial Times, March 24, 2017. 
3 See “Passive Investing: Reshaping Financial Markets?,” Acadian Asset Management, January 2017. 
4 The academic literature around index addition/deletion events dates back to the early 1980s. Particularly with respect to the S&P 500, analyses often focus on additions. S&P adds a stock to the index in response to a deletion, which may result from a delisting, restructuring, or substantial violation of one or more addition criteria. For more information, see S&P U.S. Indices Methodology, S&P Dow Jones Indices, April 2017. For deletions, it may be particularly difficult to distinguish the impact of reduced demand from index tracking funds from that the change in circumstances triggering a stock’s removal from the index. 
5 S&P Dow Jones Indices, Annual Survey of Indexed Assets, as of December 31, 2015. 
6 Investment Company Institute, 2016 Investment Company Factbook, 2016, p. 45. 
7 See Antti Petajisto, The Index Premium and Its Hidden Costs for Index Funds, Working Paper, April 8, 2010. 
8 Perhaps reflective of such changes, the chart shows evidence that speculative activity around additions is occurring further in advance of the event – on average, run-ups appear to start earlier and prices peak prior to the addition date. 
9 Such complications likely explain the infrequency of similar tests in academic and practitioner literature. In a still-often cited 2002 working paper, Morck and Yang tried to parse out a valuation premium among S&P 500 companies by identifying a meaningful sample of similarly-sized firms from outside the benchmark. They argued that – at the time – this process generated evidence of a substantial, increasing index valuation premium. But the approach is complex and could introduce new biases. (See Randall Morck and Yang, Fan, The Mysterious Growing Value of S&P 500 Membership, Working Paper, Jan 17, 2002.) 
10 More broadly, as discussed in a 2016 Acadian white paper comparing CAPE’s out-of-sample predictive ability to a composite forecast, other reasonable valuation approaches might not look as pessimistic. Gordon Growth-based P/E measures, for example, would tend to look less bearish, attributing a portion of the valuation premium to rising real returns on equity. 
11 Investment Company Institute, 2017 Investment Company Factbook, 2017, p. 46.

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