Wall Street's fear of passive investing is misplaced

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(Bloomberg Gadfly) -- Wall Street's passive aggression may be going too far.

This week a team of stock market strategists at Bank of America released a report suggesting investors may no longer be safe from index and ETFs. The report, titled "The ETF-ization of the S&P 500, Part 1" (part two is not out yet), argued that passive investing is already making the market less efficient and that it might soon make investing in stocks generally even riskier.

Indeed, the statistics in the report seem ominous for people who worry about the over-indexation of the stock market, which seems to be everybody these days. Passive now accounts for 37% of U.S.-based fund investments, nearly double the level in 2009. What's more, Vanguard, the giant indexer, now owns more than 5% of 491 companies in the S&P 500, up from 116 in 2010.

The biggest concern of the report is that passive investing is about to make the market a lot more volatile, a key way Wall Street measures risk. The strategists found that stocks that had the highest passive ownership were more susceptible to price swings than the rest of the market because fewer shares were available for trading, exacerbating the impact on prices. The implication is that as the rest of the market becomes more passively managed, it will become more volatile as well.

Active management gets a black eye when funds can’t keep pace with indexes, especially when the shortfalls aren’t short-term.
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The problem is that the stocks that Bank of America's research appears to be based on are those that would most likely be volatile whether they were owned by index funds or not. Kohl's is high on the list, as are other retailers, including Staples and Gap. Traditional retailers are at the top of the list of businesses investors are most worried about being crushed by the internet. Energy stocks also make up a big portion of the list. The top company on the list is People's United Financial, which a Morningstar report just listed as one of the banks in the U.S. most exposed to retailers.

The macro picture doesn't really back up the strategists' worries either. The rise of indexing has coincided with a drastic drop in volatility, not the other way around. In fact, along with indexing, it's the lack of volatility that has made everyone nervous that there is something wrong with the market.

The Bank of America report says that the U.S. markets will most likely get much more passive before there is a backlash. The reason there may be volatility in some stocks and not the market in general is because the 37% level is not the tipping point. Other markets in the past few years have become much more passive than the U.S., as Bank of America points out. The most striking example appears to be Japan, where just more than 60% of all the money in equity mutual funds is passively managed.

But in Japan, like in the U.S. and elsewhere, volatility has been falling. The Nikkei Stock Average Volatility Index hit a decade low of 13.28 in early June. It was as high as 92 in late 2008.

There is obviously a reason for Wall Street to be uneasy about passive investing ― it generates lower fees and is dominated by firms that have traditionally not been the powerhouses of Wall Street. And passive investing might break the market at some point, but at this point Wall Street firms are having to pull out some high-powered microscopes to spot the cracks.

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