The Passive Investing Boom Poses A New Risk: Artificial Popularity

ETFS

Shutterstock

Can’t Buy Me Love is a movie from the 1980s about a nerd who is desperate to improve his social status. In so doing, he makes an investment. He hires the most popular girl in school to be his girlfriend for a few weeks, believing this will permanently elevate his standing with the popular clique at his high school.

The plan works, kind of.

Dating head cheerleader Cindy Mancini does catapult Ronald Miller’s social status, but the good times don’t last.  Later in the film, Ronald’s plan to gain artificial popularity unravels. His new friends quickly dump him, and he becomes a social pariah.

Herding, heat-chasing—whatever you want to call it—is common in both high school hallways and on trading floors.

Every investment cycle sees popular cliques emerge. Sectors or styles that rise above the rest. The so-called “it” places to put your money.

When a stock or sector catches fire, it exhibits positive relative momentum, which attracts more capital. The positive feedback loop makes sense in the beginning. Eventually, bubbles form.

***

Today, passive mutual funds and exchange-traded funds (ETFs) comprise roughly 42% of all U.S. stock fund assets—a big jump from just 24% in 2010, and a mere 12% in 2000.

As passive investing has grown more popular, new sub-categories have been introduced, including “smart-beta” ETFs. These products are a hybrid between traditional passive and active strategies.

The ETFs are built to capture returns from specific fundamental factors, shown by academic researchers to possess historical return premiums. Smart-beta strategies surpassed $1 trillion in assets last year, according to Morningstar, and comprise roughly 18% share of the overall ETF market.

For individual stocks, the equivalent of a “varsity jacket” in factor circles these days is inclusion in momentum funds. Momentum ETFs vary in portfolio construction methodology, but the common thread throughout is an overweight in stocks with strong performance trends. “Popular stocks” you might say.

The graph below shows how the momentum factor has dramatically outperformed since 2017.

Data source: Bloomberg Finance L.P.

Fundamental factor performance normalized to 100 at start date.

Positive momentum for the momentum factor has attracted more capital to the ETFs that track it. Below is a table showing organic growth rates across the major smart-beta categories in 2018.  Momentum tops the list.

Momentum Organic Growth Leads Factor ETF Flows
Smart Beta Category YTD Flows ($ millions) Current Assets ($millions) Organic Growth YTD (%)
Momentum 1,593 12,033 16.2%
Multi 5,641 77,218 7.8%
Quality 618 9,981 6.4%
Size 2,194 50,846 4.5%
Growth 3,051 174,151 1.8%
Low volatility 440 45,126 1.0%
Value -531 173,735 -0.3%
Dividend/Yield -2,334 158,704 -1.4%

Source: Bloomberg Intelligence

Products You May Like

Articles You May Like

Micron Stock Is a Long-Term Buy, Even Ahead of Earnings
Verizon Stock Shows Its Mettle Is Solid In This Shaky Market
Stocks making the biggest moves premarket: DSW, F, GM, CVS, PFE & more
Monday’s Vital Data: Cronos Group, Tesla and American Airlines
Cuomo preparing recreational marijuana plan for New York in 2019

Leave a Reply

Your email address will not be published. Required fields are marked *