Vincent Deluard, the global macro strategist at INTL FCStone, says there's no mathematically precise way to know the moment when we hit "peak passive," but he's pretty sure that exchange-traded funds (ETFs) have ceased to be mere vehicles for tagging along with the broad market's ebb and flow. Rather they have become so popular that they are having a real—even active—impact on the securities they are supposed to be passively tracking.

Deluard told Investopedia by phone that when he began tracking them ten years ago, "ETF flows were kind of a niche industry. Of course, the world has changed ... back then, the ETF flows were dwarfed by mutual fund flows." According to BlackRock, assets in U.S.-listed ETFs and their ETN cousins quadrupled from 2007 to 2017. 

Deluard sees a link between this trend and "the somewhat absurd valuations [that] we are seeing in some pockets of the market," the reason being that ETFs "do not do what John Bogle"—the father of passive investing—"wanted them to do." Rather than simply distributing investors' capital among stock in proportion to their share of the market, ETFs introduce distortions.

"The momentum ETFs tend to invest in the same stock as the low-vol ETF, which invests in the same stock as the quality ETFs and so forth," Deluard explains. "You have these self-reinforcing biases across the industry."

Tech stocks, in general, have benefited from the popularity of the PowerShares Nasdaq ETF (QQQ), healthcare stocks from the Healthcare Select Sector SPDR Fund (XLV). In short, Deluard argues, "the ETF bubble feeds the stock market bubble."

Certain ETFs create distortions in valuations because they end up investing in many of the same stocks.

Niche ETFs

The situation is even worse with niche ETFs, "the exotic ones that are kind of like marketing gimmicks, like the robotics ETF, the artificial intelligence ETF, the cybersecurity ETF." The vehicle's ability to distort the price of the underlying securities becomes much clearer when "you're targeting an index that has like four stocks in it and three of them don't even do what the title says." 

Far from being a passive way of tracking a sector, the ETF became one of the most powerful forces in that sector. As Deluard puts it, "it's the tail wagging the dog." 

ETFs' tendency to distort large-cap valuations is arguably avoidable. Deluard says that ETFs that buy based on float, rather than on market cap, "truly do passive, meaning they don't try to pick sectors, they don't try to pick styles, they just try to invest in the stock market, passively replicating its structure." He puts the proliferation of themed and smart beta ETFs down to fees.

The cheapest index funds charge a few basis points, while some smart beta ETFs charge 50. As for small, illiquid markets, they have always been vulnerable to distortions, so buyer beware.

Key Takeaways

  • The shift from ETFs being entirely passive to now being more active, thanks to smart beta and other strategies, is detrimental to the overall stock market, says INTL FCStone’s Vincent Deluard.
  • Niche ETFs disrupt smaller industries where there are lower market caps and fewer stocks.
  • Passive ETFs, however, tend to vote with management on most issues, failing to keep in check executives and their pay.
  • Deluard’s five things that could result from a market that’s too passive (i.e. filled with ETFs) include high valuations, low volatility, massive inequality, lack of competition, and lower structural growth.

ETFs Are Too Hot

What really worries Deluard is what happens if the rush into passive continues. His vision of "peak passive" recalls Lord Kelvin's prediction of the ultimate heat death of the universe—but (hopefully) limited to the market:

"As you have more and more money going into index funds, capital markets stop working because no one's trying to value stocks, no one's researching anything, and capital markets stop allocating capital efficiently. The whole reason we have a stock market supposedly is so that people's collective intentions allocate capital to the best sectors, best stocks, best opportunities, whatever. So if everyone's passive and everyone gives up, you end up with a stock market that's forever frozen. You keep investing based on how big a company is so that nothing ever changes. You couldn't even have an IPO at this point."

ETFs have taken their toll. Five things would presumably result from an overly passive market, Deluard says: "high valuations, low volatility, massive inequality, lack of competition and lower structural growth. And I think that these five things are things that characterize fairly well U.S. markets and the U.S. economy in general."

ETFs Create Inequality

Deluard explained "massive inequality," pointing to the ratio of CEO pay to the average worker's, which has increased from 20 in 1965 to 271 in 2018.

"From the perspective of a company manager," Deluard says, "passive investors are the best kind of investors you can have. They vote with management, they don't do proxy battles, they don't do hostile takeovers, all the inhibiting factors in corporate democracy are gone with passive investors."

A study found that 1,662 U.S.-listed companies count the big three ETF providers—BlackRock Inc. (BLK), the Vanguard Group Inc. and State Street Corp. (STT)—as their largest shareholder, taken collectively: 77.9% of the U.S. public market by value can count on a passive bloc to vote with management over 90% of the time. 

The authors of that study, Jan Fichtner, Eelke Heemskerk, and Javier Garcia-Bernardo of the University of Amsterdam, suggest that this situation drives up executive compensation, and Deluard agrees. "That big explosion in executive compensation happened in large part because corporate governance weakened."

Combating the ETF Problem

What should an individual investor do in the face of these trends? Deluard takes a mixed approach. He invests half of his personal funds passively—using truly passive, float-adjusted funds—since he thinks that to ignore the trend would be like jousting, Don Quijote-style, with windmills.

With the other half, he tries to take advantage of the opportunity the passive economy creates. Since investors are "free-riding on the research of others," many stocks—particularly small caps—slip under the radar. By going with active, "crazy" ideas such as well-capitalized Italian banks, he's gotten burned occasionally, but he's also made some money.

One thing people in the passive economy tend to forget: "It's kind of fun to research stocks."