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Popularity of passive investing changes rules of the game

ETFs, which provide a low-cost way to invest in a basket of assets such as an index, now regularly account for a third of the trading on the US stock market and an even larger share in periods of high volatility.

Article originally published by The Financial Times. Hargreaves Lansdown is not responsible for its content or accuracy and may not share the author's views. News and research are not personal recommendations to deal. All investments can fall in value so you could get back less than you invest.

The proliferation of exchange traded funds since the financial crisis is one of the more important — and most contentious — developments in global capital markets over the past decade.

More than $3.5tn in new cash has moved into ETFs over the past 10 years in a tectonic shift that has implications for investors worldwide.

ETFs, which provide a low-cost way to invest in a basket of assets such as an index, now regularly account for a third of the trading on the US stock market and an even larger share in periods of high volatility. At the same time, overall US liquidity — equity trading volume as a share of market capitalisation — has been on a downward trend since 2009.

These developments represent “a sea change” for investors, according to Savita Subramanian, head of US equity and quantitative strategy at Bank of America Merrill Lynch.

“Investors assume that the S&P 500 [the main US equity market benchmark] is a super liquid universe but growth in the shares held by ETFs and other index fund managers has reduced the availability of stocks for trading for other market participants,” says Ms Subramanian.

The bank analyses holdings by passive ETFs and active managers, and has found that “stocks that are more widely held by ETFs and passive mutual funds display systematically higher volatility than the stocks that are less widely held by those same funds”.

These volatility effects are important as trading desks are regularly asked to prove “best execution” on transactions to show that they have not incurred unnecessary costs.

Understanding the interactions between ETFs, cash equities and derivatives has become a vitally important study for a range of market participants including hedge funds, investment bank trading desks and fund managers.

Michael Steliaros, global head of quantitative execution at Goldman Sachs, says that the rise of passive ETFs and index-tracking funds influences the dynamics of individual stocks, which has implications for the ways that investors build and manage their portfolios.

A Goldman analysis found the relationship between passive ownership and stock volatility in both the US and Europe tends to grow stronger as the trading session progresses. It is strongest in the hours before the closing auction, as well as the auction itself, when the final price of a stock is determined.

This is a result of the large portfolio trades that are executed around the close when all of the stocks held by an ETF are traded simultaneously as part of a rebalancing exercise or to accommodate new cash inflows.

These shifts in volatility can influence how a trading desk might size and sequence transactions. “It is important to understand how the effect of passive ownership of stocks works — it has significant implications for when a trading desk might choose to execute a transaction,” says Mr Steliaros.

The penetration of ETFs into non-US markets is far lower but rising fast. Goldman found the volatility of European listed shares is even more strongly influenced by ETFs. This is partly because a far higher share of ETF trading in Europe is conducted between two parties in private, whereas most ETF dealing is done on an exchange in the US.

Differences in the mechanics of closing auctions in both regions can also have an impact on the intraday volatility. The New York Stock Exchange and Nasdaq release order-book data prior to the closing auction, which provides a much clearer indication of available liquidity. But in Europe the auction is conducted “blind” and participants have much less information on which to base buy and sell orders. This affects stock volatility at the start of the following day as European trading desks readjust their books depending on what data has arrived overnight.

Jonas Lindqvist, head of product strategy for principal trading at Itiviti, a Swedish technology company, says the high volume of trading on behalf of ETFs and mutual funds during closing auctions in Europe has an impact on the final price. The priority for ETFs is to ensure they buy and sell at the valuation determined by their benchmark index. As a result, they are less concerned about the exact price and could expose themselves to being gamed by more nimble traders, he says.


This article was written by Chris Flood from The Financial Times and was legally licensed through the NewsCred publisher network. Please direct all licensing questions to legal@newscred.com.

Article originally published by The Financial Times. Hargreaves Lansdown is not responsible for its content or accuracy and may not share the author's views. News and research are not personal recommendations to deal. All investments can fall in value so you could get back less than you invest.

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