Passive: Evading the Choices
Attention à l'impasse
The Rise of ETFs
Over the past two decades, passive investing has gained significant popularity. By the end of 2022, ETFs in the US and Europe amassed $6.7 trillion in assets under management (AUM), growing at an impressive 15% compound annual growth rate over the last 12 years—three times the growth rate of mutual funds.
Understanding ETFs
Mutual Funds vs. ETFs
Mutual Funds:
Operate on a creation and redemption process.
Investors pool their money into a mutual fund and receive shares proportional to their investment.
For example, four individuals each invest $10,000, receiving 10 shares each if the fund totals $40,000.
The Net Asset Value (NAV), calculated post-market close, determines the share value based on the fund’s assets.
ETFs:
Trade continuously on the open market, unlike mutual funds.
Investors buy and sell shares directly with other market participants.
An authorized participant (AP), typically large banks, facilitates the creation and redemption process.
Role of the Authorized Participant (AP)
Creation:
The AP acquires the desired securities for the ETF.
The ETF issues a basket of shares to the AP, known as a “create.”
Redemption:
The AP returns ETF shares to the fund.
In exchange, the ETF provides a basket of securities.
AP as Arbitrageur:
Ensures the ETF’s market value aligns with the underlying securities.
Buys or sells ETF shares to maintain equilibrium.
Example of Arbitrage
If ETF’s basket is worth $25 but trading at $25.10, the AP sells ETF shares and buys underlying securities.
Conversely, if trading at $24.90, the AP buys ETF shares and sells underlying securities.
Tax Efficiency
In-kind transactions (security-for-security swaps) avoid taxable events.
ETFs can avoid capital gains distributions by selectively redeeming shares with the lowest cost basis.
Implications of Passive Investing
Market Dynamics:
Increased efficiency and accuracy with methodologies like the S&P Float Adjustment.
Potential distortions, as heavy inflows into index funds concentrate money in top stocks.
Market Concentration:
The top four money managers hold over $25 trillion in AUM, heightening idiosyncratic risk.
Co-movement of Securities:
Passive investing leads to higher correlations among securities.
Financial shocks may have amplified effects across the market.
Valuation Gaps and Momentum:
Discrepancies in valuations, particularly in the largest and smallest names.
Opportunities for alpha extraction due to momentum swings.
Passive investing, while beneficial in many aspects, presents unique challenges and risks. Understanding the mechanics of ETFs and the broader implications of passive investing is crucial for investors navigating today's market.
ETFs have ultimately created a scenario in which investors own little securities. This passive environment is one which will harm the market dynamics going forward.
- mickey