A collaborative study of institutional trades by U.S. academics revealed that a rise in passive investing within the last 20 years is showing more inelastic demand curves for individual stocks by 15%. As a result, market efficiency has become disrupted.
A Financial Times article, which explained this study, noted that the “analysis raises fresh questions about the widespread adoption of index-based investing, a trend that has allowed investors to save billions of dollars a year in the shape of lower fees — seemingly without hurting returns.” However, lower fees could be translating to more market fluctuations, which investors have been seeing for the first half of 2022.
In effect, passive investing should have a demand elasticity of zero, the article explained. A rise in passive investment is pushing the market’s aggregate elasticity down, but less active trading is reducing overall demand elasticity, thereby creating an imbalance in market efficiency.
There quite simply aren’t enough active traders to counteract the forces of passive investing, which could result in more volatility. When the markets move one way, passive investing strategies will sway in that direction and vice versa.
“Markets [have] become less efficient from the rise in passive investing,” said Valentin Haddad, associate professor of finance at UCLA Anderson School of Management.
“Passive money is not paying attention to any information. Efficient market hypothesis proponents say it’s not a big deal because others will come in,” added Haddad. “But not enough people are showing up to trade. You have less information in the market, less aggressive trading, less accurate prices and a more volatile market.”
An Active Solution to Low Volatility
To help reduce volatility, exchange traded fund (ETF) investors can opt for funds that incorporate active management. One fund to consider is the American Century Low Volatility ETF (LVOL), which gives investors exposure to active management, meaning that portfolio managers can check the pulse of the markets and get in or out of positions depending on how the market is behaving.
This dynamic exposure comes at a low-cost expense ratio of 0.29%. The fund screens for asymmetric, or downside, volatility and invests in companies with strong, steady growth.
Key features of the fund as presented on the product website:
- Emphasizes strong fundamentals to limit potential risk of speculative companies with questionable profits.
- Expands risk measures beyond volatility to capture other downside and balance sheet risks.
- Focuses on volatility at the portfolio level as well as the individual stock level.
- Uses a rebalancing strategy that actively responds to changing market conditions.
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