IMF finds over-indexing a threat to market stability

Passive investing could pose a threat to global financial stability if the sector’s growth continues unabated, according to a new International Monetary Fund (IMF) study, published last week.

In an updated chapter to its ‘Global Financial Stability’ report, the IMF says the prolonged low-rates, low-return period has given a tailwind to the “already remarkable growth” in index funds.

“The growth in index funds can present a challenge to financial market efficiency,” the IMF study says. “Indexing promotes access to financial markets at lower cost, and should facilitate portfolio diversification.

“However, as index investing through exchange-traded funds has become more prevalent, it appears to have increased the role of non-fundamental factors in determining both asset returns and their co-movement.”

IMF figures show passive products represented about 12 per cent of the US equity managed fund market and almost 3 per cent of bond/hybrid funds in 2015 compared to under 2 per cent and close to zero per cent, respectively, just 10 years previously. Last year Morningstar reported index products made up about a third of the US mutual fund market.

The IMF says if indexing becomes the dominant investment style “price discovery could be hampered and markets could become more prone to swings in sentiment”. Furthermore, the study says the benchmarking trend “appears to motivate even sophisticated investors to overweight high-beta assets”.

But in addition to fuelling the index fund explosion, the IMF report says the extended period of low interest rates and low returns was also driving further consolidation in the active manager market.

“Prolonged low rates may promote further growth in the average size of mutual funds and of the relative importance of index funds,” the study says. “Low asset returns under an equilibrium with low natural interest rates will combine with competitive pressure on mutual fund fees to make it increasingly difficult for smaller funds to survive…

“… the combination of larger fund sizes and increasing passive index investing carries potential new financial stability risks because of less diversity on the buy side and investors’ greater proclivity to respond in the same way to shock.”

The IMF argues in the ‘Low growth, low interest rates, and financial intermediation’ chapter that the intertwined trends of indexing growth and active manager consolidation constitute one of the three potential threats to wider financial market stability of an expanding global asset management universe.

According to the IMF, growing exposure to illiquid assets via managed funds and “herd behavior among fund managers (which can be destabilising)” reinforced the case for greater oversight of the sector.

“Surveillance and regulation of asset management activities would become even more important as this industry’s share of the financial system grows,” the IMF study says. “In particular, further strong growth of index investing could entail new financial stability challenges. Closing significant data gaps would also be essential to allow for effective macro-prudential surveillance of this sector.”

– Investment News NZ