Who drives stock markets?
I am currently thinking a lot about the interaction between different types of investors. This question is highly relevant for many reasons, but currently, the most common question, investors ask if ETFs can cause market failure or some form of systemic risk. The European Systemic Risk Board (ESRB) has recently published a wonderful overview paper on the research that has been done to investigate the potential systemic risk ETFs pose.
I won’t discuss the question of ETFs as a systemic risk here, but one thing that worries me is that the rise of passive investments can – at least theoretically – lead to a misallocation of capital insofar, as relative valuations between stocks are locked in. If Apple is overvalued and suddenly the whole world switches to index funds based on market cap weighted indices, then Apple would remain overvalued forever because nobody would actively underweight Apple shares relative to the market and drive down the share price.
In order for markets to remain as efficient as possible, we need active investors who deviate from benchmark indices. And here comes the good news: it seems as if there are still plenty of investors around who do just that.
A paper by Ralph Koijen, Robert Richmond and Motohiro Yogo looked at the ownership structure of stock markets in the US, the UK and some other regions and tried to identify the influence of different investor groups on stock prices. They differentiated between seven different investors:
Investment advisers: These are the big asset management firms like Blackrock and Fidelity.
Mutual funds: These are the true mutual fund firms that are owned by the investors, like Vanguard.
Long-term investors: These are the classical institutional investors like pension funds, sovereign wealth funds and endowments.
The chart below shows the share of ownership of the US and UK stock markets for each of these seven investor types. In both markets, as indeed in every major stock market, the largest group of investors are the investment advisers followed by private households, mutual funds and long-term investors.
What makes the research of Koijen and his colleagues so interesting is that they looked at how demand for stocks changed as different characteristics of a stock, like valuation, profitability etc. changed.
And this is where the good news for investors starts. The researchers found that as stock characteristics change, the investment advisers and hedge funds react and change their stock holdings. Hedge funds react most sensitively to changing characteristics of stocks, but because they are such a small part of the overall market, their impact on share prices is relatively small. However, the impact of the investment advisers is much larger, both because they shift demand for stocks as their characteristics change and because they control about one third of the market.
Despite the rise of ETFs and other passive investment vehicles, investment advisers, hedge funds and mutual funds still move prices and create a levelling force that makes markets more efficient.
The researchers estimate that if all investment advisers would suddenly switch their portfolios to passive index portfolios, the market cap of the US stock market would increase by about 30.2% and in the UK by about 8.6%. Some of the largest stocks in the world, like Apple and Alphabet, would see their market cap jump by about two thirds if investment advisers would all switch to passive investing. Why? Because on average these active investors are underweight some of the biggest companies in the world. On the other hand, they tend to be overweight smaller companies and high growth companies, which would lose market cap if investment advisers would switch to passive.
Thus, their research indicates that active managers are still the ones who set market prices for different companies and neither passive investors nor long-term investors and households seem to have a material influence on stock market prices. They continue to remain price-takers. And that, in turn means, that markets, at least for now should remain relatively efficient.
As long as prices are driven by active managers (be they investment advisers, mutual funds or hedge funds) there is a competition of views that drives stock markets towards a more efficient state. That does not mean that active managers get it right. We all know they don’t and the result can be serious deviations from fair value in single stocks or the overall market. But at least we know, the markets are not broken due to the rise of passive investing. I think, we should repeat the study of Koijen and his colleagues regularly to see if the influence of active investors on stock prices declines over time. And if we see that the influence of active investors becomes marginalized, then we can start worrying about the risks of ETFs to the market.
Share of ownership of stock market
Source: Koijen et al. (2019).