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Passive Funds Dictate Prices, Undermining True Valuation

Torsten Slok, Apollo: "The market is increasingly three passive index funds...With the three largest passive S&P 500 funds now holding more than $2.6 trillion combined...prices are increasingly set by mechanical flows rather than by anyone judging what companies are actually worth." In my report earlier this year on "Price Discovery" (https://t.co/kEx5Z4BJH7), I dissect all the ways in which market participation shifts have altered equity dynamics. The rise of passive is obviously central to that dissection. The primary distortion they've instigated: reduced stock elasticity as there's less active selling against persistent passive buying. As the Economist put it, recapping findings by Xavier Gabaix and Ralph Koijen: "Funds that maintain fixed allocations can push up prices. Suppose you exchange cash for new units in a fund promising to keep 80% of its assets in shares. The number of shares in existence does not change, but demand for them has risen." To quote from the report: "We find it hard to believe the rise of passive hasn’t altered price discovery for one very basic reason: passive ETFs aren’t actually passive participants in markets; they actively buy and sell equities based on inflows and outflows. It’s unclear what percentage of daily trading volume is attributable to passive funds. Vanguard has claimed that passive’s share of trading volume is a “drop in the bucket”—less than 5%—and therefore, irrelevant to equity-market price discovery. One of passive’s staunchest critics, Simplify’s Michael Green, has challenged that as disingenuous, claiming passive can at times drive 80% of daily trading volume, from direct trading by ETFs to the market-making by HFTs that facilitates ETFs to the options hedging that results from ETF trading. And that trading volume influences market pricing. Green summed up his thinking in a 2020 interview: 'The idea that passive players are passive players is just completely absurd. What they are is active players that have super simple rules…What we’re actually doing is sending the money to vehicles that allocate the capital on the basis of the current market cap or the current float-adjusted market cap. When you do that, first you’re presuming that the market has actually done the work to say that the current level of price is the right price. Second, you’re concluding that the price that it transacts at next is the price that it would have transacted at next had you not been involved…Prices are a little bit like Schrodinger’s cat. They tell you where something was on the last transaction, but they don’t actually tell you what the price is. The price could be up. It could be down. We don’t know that until the next transaction occurs. Passive is assuming that they’re not having any influence on that next price but they have to be because they are transacting.'" Apollo link: https://t.co/wxxB1VJ7Aa