There may be an added risk associated with the increase in popularity attached to passive funds and investments such as exchange-trade funds (ETFs), according to new research by the Bank for International Settlements (BIS). The research shows a "significant statistical relationship between firms' weight in bond indexes and how indebted they are."
The Wall Street Journal reveals data suggesting that the phenomenon may be prompting some companies to take on additional debt. What might this mean for the ETF space going forward?
Leverage Remains an Important Factor
According to the BIS report, "The largest issuers tend to [be] more heavily represented in bond indices. As passive bond funds mechanically replicate the index weights in their portfolios, their growth will generate demand for the debt of the larger, and potentially more leveraged, issuers." Indeed, while larger companies are naturally likely to issue more debt than smaller ones, thus explaining their significant presence in bond indexes, this is not necessarily the best predictor of their weight. The research suggests that a company's weight in the Bank of America Merrill Lynch Global Broad Market Corporate Index was more closely tied with its leverage than with its size, regardless of whether the determination factored in all debt or just bonds. (See also: The Optimal Use of Financial Leverage in a Corporate Capital Structure.)
Passive Investment Vehicles Continue to Grow
Part of the reason that large flows of money are tending to follow market trends has to do with the explosion of interest in passive investment vehicles like ETFs in the past decade. When central bankers dropped interest rates to record low levels, thereby stifling returns for active investors, a new interest developed in the passive space. That led to significant growth – passive mutual funds managed assets totaling about $8 trillion, or roughly one-fifth of all investment fund assets, as of June 2017. This constitutes a rise of 8% over the same time 10 years prior.
The combination of these various factors, including the increased tendency to be indebted and the growth of passive vehicles, has some analysts concerned that moves could be amplified in a dangerous way. One example would be if a large number of investors attempt to exit from highly liquid vehicles at the same time. Bond ETFs may be in especially problematic territory, as debt markets are more diverse than stocks and simultaneously less traded. (For more, see: Bond ETFs: A Viable Alternative.)
One of the next aspects to be considered in this line of research has to do with the impact that inclusion in passive indexes might have on issuers of equity and debt. For the time being, this remains difficult to assess, with economists not agreeing on the particular implications. Similarly, there are reasons why passive investment vehicles remain beneficial and enticing options, according to the BIS report. Although including a company in an index may encourage leverage as a result of generating increased demand for that company's debt, reducing issuance costs and improving bond liquidity may have beneficial effects as well, according to the report.
What's more, ETFs show no signs of slowing down. A report by MarketWatch suggested that 2017 inflows for ETFs as a group totaled $464 billion. This was nearly double the inflows record for the previous year and more than five times the level of inflows for mutual funds over the same period. The MarketWatch report also indicates that the ETF space had grown by more than $1 billion in less than a year's time as of the first days of 2018. However, even as individual and institutional investors alike turn to ETFs on the strength of data suggesting that passive strategies are more successful than active ones, there may be other issues that could take effect as the industry continues to grow. (For additional reading, check out: Active vs. Passive Investing.)