B. of A. warns the rise of ETFs is distorting the stock market – MarketWatch

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Appearances can be deceiving.

The number of passive investors who trade stocks via exchange-traded funds has surged in recent years in what some see as a sign of a dysfunctional market in the making.

Strategists at Bank of America Merrill Lynch, led by Savita Subramanian, earlier this week warned in a report that the surge of ETFs is distorting the stock market and making it less efficient in the process.

Bank of America Merrill Lynch

ETFs currently account for nearly a quarter of U.S. stock-market trading volume versus 76% for individual stocks. Three years ago, ETFs accounted for 20%. Meanwhile, the percentage of equity-fund assets has jumped in the wake of the U.S. financial crisis, rising to 37% in 2017 from 19% in 2009, according to Bank of America.

Bank of America Merrill Lynch

“Investors have increasingly shifted to passive investments: Clients have been net buyers of over $160 billion in ETFs versus net sellers of over $200 billion in single stocks since 2009,” said Subramanian, citing Bank of America Merrill Lynch’s equity client flow data.

At the forefront of this charge has been Vanguard, whose share of the S&P 500 SPX, +0.15%  market capitalization doubled from 2010 to 6.8% today, Subramanian said. In fact, the number of S&P 500 stocks in which Vanguard holds more than a 5% stake totaled 491 recently, versus 116 in 2010. Put another way, only nine stocks in the S&P 500 are not owned by the investment management giant or have less than 5% Vanguard ownership.

Bank of America Merrill Lynch

Passive investing, by any definition, is nothing more nefarious than a different approach to buying and selling stocks. However, its popularity may be contributing to the numbers being skewed.

“The actual shares available, or ‘true float’ — float shares, less shares held by passive funds — for S&P 500 stocks, may be grossly overestimated,” said Subramanian.

This may have unexpected consequences for investors, as the average price volatility of stocks with large ownership by passive players has tripled in the past 12 months.

“But the earnings multiples of these stocks have generally been in-line to higher than that of the market, not necessarily reflecting heightened liquidity risk, in our view,” she said.

It also exposes crowded stocks that have generated a great deal of interest to greater risks, suggesting that investors will be better off focusing on shares that have been ignored.

Under-owned stocks, according to the strategist, have outperformed those with low price-to-equity ratios or high-growth names over a span of three months.

“Crowded stocks have generally underperformed‎ neglected stocks as mutual funds are net sellers and passive funds are net buyers. Crowding risk is particularly acute at quarter-end when allocators tend to rebalance,” she said.

For a glimpse of what a market increasingly driven by ETFs looks like, Subramanian pointed to Japan.

“In Japan, nearly 70% of the assets under management of Japan-focused equity funds is passive — granted, the BoJ has been buying ETFs — and their markets are still functioning,” she said.

But it has come at a price. The number of active funds outperforming Japan’s Tokyo Stock Price Index has fallen to 34% between 2014 to 2016 from 46% between 2002 to 2013.

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