The dramatic rise in passive investing has not been without controversy. Wall Street has ridiculed it for years because the price discovery efforts of active managers help ensure that prices correctly reflect fundamental value and keep markets efficient. The failure of active managers to demonstrate the ability to persistently outperform beyond the randomly expected has helped fuel the movement toward passive strategies. In its report, “Asset & Wealth Management Revolution: Embracing Exponential Change,” PWC estimated that, by year-end 2025, the total assets under management that are passively managed will have grown to around $36.6 trillion, representing approximately 25% of global assets under management.
The growth in passively managed assets has led to many questions about the impact on market liquidity and market efficiency. To try to answer these questions, Philipp Höfler, Christian Schlag, and Maik Schmeling, authors of the October 2023 study “Passive Investing and Market Quality,” examined how passive exchange-traded-fund ownership affects measures of market quality such as liquidity, the likelihood of extreme price movements, and how new information is impounded into prices. The amount of assets in ETFs (almost 100% of which are passively or systematically managed) grew from just over $100 billion in 2002 to more than $7 trillion by the end of 2021 before falling to $6.4 trillion at the end of 2022 (caused by the bear market in stocks and bonds).
Their data sample included 872 ETFs and covered the period June 1997 to December 2021. Following is a summary of their key findings:
- Firms with high ETF ownership exhibited higher turnover and lower volatility.
- An increase in passive ETF ownership led to stronger and more persistent return reversals—stocks in the high passive ownership quintile fell by about 1% over the subsequent 50 trading days before the effect leveled out, while stocks with low passive ownership initially fell by only about 10 basis points and quickly recovered afterward. Short-term reversal strategies go long (short) stocks with low (high) returns over a recent period and trade on the tendency of stock returns to revert after liquidity-induced price bounces. Thus, the size and speed of reversals inform the ability of market makers to satisfy liquidity needs (market-making capacity) and the profits to liquidity provision by market makers.
- Increased passive ownership caused higher bid-ask spreads, more exposure to aggregate liquidity shocks, more idiosyncratic volatility, and higher tail risk (more prone to extreme price moves).
- A one-standard-deviation increase in passive ownership raised left and right tail risk each by about 19 percentage points.
- Decomposing stock return variance into marketwide news, firm-specific (public and private) news, and return noise (based on sentiment measures, including the Baker and Wurgler score), higher passive ETF ownership reduced the importance of firm-specific information for returns but increased the importance of transitory noise and a firm’s exposure to marketwide sentiment shocks—a one-standard-deviation increase in passive ETF ownership raised the variance share of noise by about 6 percentage points but decreased the share of firm-specific information by 9 percentage points.
- Higher passive ownership increased the exposure of stocks to marketwide sentiment shocks (higher indexing increases the importance of discount rates) as well as stock mispricing (based on a mispricing score from the 2012 study, “The Short of It: Investor Sentiment and Anomalies”).
- Their results held when they included passively managed mutual funds—the results were not specific to mutual funds.
Their findings led Höfler, Schlag, and Schmeling to conclude: “Our results suggest that the decrease in liquidity that comes with more passive ETF ownership stems from an increase in short-term noise trading, which decreases the importance of firm-specific news for stock returns but amplifies exposure to transitory, market-wide shocks.”
The empirical research demonstrates that higher passive ownership decreases market liquidity (higher bid-offer spreads), decreases the informativeness of stock prices by increasing the importance of nonfundamental return noise, reduces the contribution of firm-specific information, increases the exposure to stocks of shocks to discount rates, and increases the tail risk of stocks.
With those insights in mind, what effect has the increase in passive ownership had on the ability of active managers to add value? The active community argues that less informational efficiency and less price discovery by active managers leads to market mispricing and more opportunity for active managers to add value. Unfortunately, the evidence, as presented in my 2020 book The Incredible Shrinking Alpha, cowritten by Andrew Berkin, demonstrates that while passive’s share has increased, the percentage of active managers generating statistically significant alpha has fallen from about the 20% level (reported by Charles Ellis in his 1998 book Winning the Loser’s Game) to about 2% today. And that’s even before considering taxes.
One reason is that while the evidence suggests that the market has become less informationally efficient, implementation costs (bid-offer spreads and market-impact costs) have risen as liquidity has been reduced.
As Berkin and I explained in our book, other factors have also been making it harder to generate alpha: The publication of research has converted what was once alpha into beta (common factors that can be accessed at low costs through passive/systematic funds such as index funds); the amount of assets chasing reduced sources of alpha has grown dramatically; and the pool of naive retail investors who can be exploited has been shrinking.
The takeaway for investors, then, is that while the trend toward passive investing has negatively affected the market’s informational efficiency, active management has actually become even more of a loser’s game.
The views expressed here are the author’s. Larry Swedroe is head of financial and economic research for Buckingham Wealth Partners, collectively Buckingham Strategic Wealth, LLC and Buckingham Strategic Partners, LLC.
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Larry Swedroe is a freelance writer. The opinions expressed here are the author’s. Morningstar values diversity of thought and publishes a broad range of viewpoints.
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