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Equity Outlook  |  Q1 2018

The shift to passive strategies presents risks for all investors

David L. Diamond, CFA

David L. Diamond, CFA
Portfolio Manager of Putnam Small Cap Value Fund

Since the early 2000s, equity investors have seen a variety of structural changes in market dynamics. Among the most dramatic has been an increase in passive strategies — a trend that I believe presents risks that many investors may not fully appreciate or understand.

Across equity markets, the percentage of passive investments — ETFs and other portfolios that are not actively managed but simply track an index — has risen dramatically. As this passive money pours into stocks, it creates a disruption in the traditional flow and balance of equity market activity. In my view, the downside of this disruption could become painfully clear with the next significant market correction.

The risk of a selloff that’s blind to fundamentals

For quite some time, we have had a one-dimensional market. Stocks have been performing well with historically low volatility, and we are in the midst of the second-longest U.S. bull market in history. At the same time, passive assets represent an increasingly larger portion of the market. This is capital that is essentially blind to fundamentals. These assets don’t move based on research and judgements about earnings growth, balance sheets, or valuations. Much of today’s equity flows are based on quantitative models or computer-driven trading, with price momentum as a primary driver of outperformance.

Historically, when equity markets experienced a correction, active managers conducting rigorous research would seize on buying opportunities based on fundamentals. This helped create a balance that may be missing in today’s market. With a much smaller pool of “active” money — fewer active managers to buy in a selloff — an equity market correction could be considerably more severe, particularly for small- and mid-cap stocks, which tend to be less liquid. And if the downturn is too sharp, even active managers may dismiss some buying opportunities in an attempt to mitigate further risk. Small- and mid-cap stocks with the highest proportion of passive ownership could be hit the hardest in a downturn as investors make indiscriminate reductions in ETF and index holdings.

Managing risk through shifting market dynamics

Like most risks, it is impossible to predict how harshly passive strategies might impact the equity markets. But it is a risk we are constantly monitoring and assessing, working with quantitative analysts and data scientists to understand the impact of passive exposure and to develop strategies for managing it as part of our portfolio construction process. We have screens that rank stocks by passive exposure across our investment universe. Like balance sheet metrics and other fundamental screens, this is another important data point we consider.

Next: Can China avoid a hard landing?

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