Institutional Perspectives

Key Takeaways

• The proliferation of passively managed ETFs facilitates potential misallocation of capital.
• Several research papers have found that stocks owned by ETFs exhibit higher levels of risk and cost in the form of volatility, trading costs and co-movement with other stocks.
• A fundamental bottom-up research platform with a long-term investment horizon, such as what we have at ClearBridge, should hold up well in the face of passive ETF distortions.

Are ETFs distorting the structure of the equity market and/or the underlying securities?

This is obviously a critical question for active managers and unsurprisingly a hot topic in the financial media. The short answer is yes for the underlying securities, and thereby the market, and we are starting to see more evidence of this in the press, white papers, and academic papers.

There are numerous ways of showing the rising tide of ETFs, such as Exhibit 1, which illustrates there are currently more than three times as many equity ETFs and nearly 2.5 times as many equity ETF indexes as the number of large-cap stocks in the U.S. Furthermore, passive ETFs comprise more than 99% of the entire U.S. ETF space ($2.6 trillion, as of 2016),¹ indicating the fast-growing and dominant position such passive, index-tracking vehicles have in today’s market. This is important because the proliferation of passively managed ETFs facilitates potential misallocation of capital as ETF investors chase past performance irrespective of a security’s fundamentals, directly dislocating underlying security prices.

 

Exhibit 1: Number of U.S. Equity ETFs, Underlying Indexes and Large Cap Stocks (1995-2017)

Data includes U.S. equity ETFs with any amount of assets at the date of evaluation. U.S. large-cap stocks include Russell 1000 members with at least $10 billion market cap (inflation adjusted) at the date of evaluation. Source: FactSet, ClearBridge Investments. Data as of March 31, 2017.

 

Several research papers have found that stocks owned by ETFs exhibit higher levels of risk and cost in the form of volatility, trading costs and co-movement² with other stocks. For example, one paper found that stocks owned by ETFs exhibit significantly higher intraday and daily volatility. Specifically, the authors estimate that an increase of one standard deviation in ETF ownership is associated with an increase of 16% in daily stock volatility.³ The driving channel appears to be arbitrage activity between ETFs and the underlying stocks.

In another paper, the authors find that increased ETF ownership can lead to higher trading costs and lower benefits from information acquisition.⁴ Specifically, the authors note that an increase in “ETF ownership is associated with: (1) higher trading costs (bid-ask spreads and market liquidity); (2) an increase in ‘stock return synchronicity’; (3) a decline in ‘future earnings response coefficients’⁵; and (4) a decline in the number of analysts covering the firm.”

Another paper finds that ETF activity increases return co-movement, which is partly attributable to the timely incorporation of systematic earnings information.⁶ The paper also finds that ETF activity increases informational efficiency for stocks with weak information environments and with imperfectly competitive equity markets, but does not increase informational efficiency for stocks with stronger information environments and with perfectly competitive equity markets.

At first blush, the latter two papers, “Dark Side…” and “ETF Activity…,” may appear to contradict each other, as the latter claims increased informational efficiency with increased ETF activity, while the former claims lower information acquisition benefits with increased ETF ownership. However, “ETF Activity…” finds greater informational efficiency for smaller-cap stocks with low analyst following, and not for heavily followed large-cap stocks. Importantly, both papers find that stocks with greater ETF ownership incorporate a greater share of systematic non-company-specific information. Greater co-movement or return synchronicity of underlying stocks has also been associated with higher ETF ownership and consequently activity.

"By focusing on... the underlying business and waiting for the fundamentals to shine through in the long term, active managers should benefit."

If so, so what?

As ETF ownership increases, stock prices become more volatile and move more with the market and less due to firm-specific information. This means that relevant information (stock-specific earnings) is not being incorporated in prices, and active managers, including those with fundamental active ETF vehicles, should be able to take advantage of these time-arbitrage opportunities. Of course, this would only occur if the information eventually gets embedded in the stock prices. In the meantime, stocks heavily owned by ETFs will display higher volatility, which makes for a queasy roller coaster ride. But by focusing on the volatility of the underlying business instead, and waiting for the fundamentals to shine through in the long term, active managers should benefit.

If we were only dealing with market cap-weighted ETFs, the rapid growth of this passive asset class would result in crowding at the top of the market cap range. But a lot of growth in ETFs is coming from systematic factors such as value, momentum, quality, etc. Importantly, if a significant amount of investor funds are flowing into ETFs tracking systematic exposures, then the negative characteristics of heavily owned ETF names (increased volatility, greater co-movement, higher trading costs, etc.) would also create inefficiencies and volatility along these dimensions. A fundamental bottom-up research platform with a long-term investment horizon, such as what we have at ClearBridge, should hold up well in such an environment. At the same time, it is imperative for portfolio managers to know their exposures to these systematic factors so they can better understand the investment landscape’s impact on their portfolio(s) in their effort to maximize risk-adjusted potential return for their investors.