“A fundamental shift in market structure towards rules-based, passive investing over the past decade means a lot of trading is no longer based on fundamentals” and the shift could lead to a global market downturn, according to a recent article in the Financial Times.
The concern has risen to the Fed, who will address the topic at this year’s economic symposium in Jackson Hole.
Passive investments ignore fundamentals, the article says, citing the example of ETFs: “Often set up to mimic an index, ETFs have to buy more of equities rising in price, sending those stock prices even higher,” thus creating a “piling-on” effect. Passive investing, it adds, could also make markets more complex by sending mixed signals to active investors about the fair value of stocks, causing a “significant misallocation of capital.” The situation is made worse by the speed at which trading is now conducted, the article notes.
“Systemic failures, misallocation of capital and dried up liquidity could cause a bear market, dragging on growth when the economic backdrop is already lackluster,” the article concludes, warning us not to be fooled by the country’s second-quarter GPD growth of 4.1 percent. “The underlying fundamentals of the U.S. economy leave a lot to be desired. A market crash—worsened by systemic effects—would probably send the economy into a tailspin.”
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