How this crash pierced two myths about passive investing

Alex Rosenberg, an editor in Citywire’s New York office, says two criticisms aimed at passive investing have been proven wrong in this stock market crash.

There have long been two criticisms of index funds and passive investing, one concerning their liquidity and the other concerning their performance. 

Exchange-traded funds (ETFs) used by passive investors appear to be both wonderfully liquid and outperforming more expensive active managers, but both the liquidity and the outperformance are illusory, critics have claimed – and in a crisis, liquidity will disappear and the passive bubble will pop. Investors will realize the folly of their ways, and turn back to tried-and-tested active funds, and perhaps single stocks and bonds. 

The crisis has now arrived. So, what have we learned about ‘the liquidity illusion’ and ‘the performance illusion’? And perhaps more importantly: is the era of index funds over?


Arguably, the biggest story in investing over the past decades has been the rise of index funds. The history goes back to 1975, when Jack Bogle launched the First Index Investment Trust with $11m. Inspired by Charles Ellis’s classic 1975 paper The Loser’s Game, Bogle argued vociferously that since the mass of all institutional investors was essentially the market, on average, the investor in an active fund would receive the active return minus fees. He encouraged investors to think in terms of fees rather than performance, and since tracking an index or broad grouping of equities or bonds takes significantly less work than choosing securities and trading in and out of them, these are the types of funds he promoted. 

His argument proved convincing, to say the least, particularly in US equities. Assets managed by passive US stock funds outstripped assets managed by such active funds in 2019, according to Morningstar data, and Bogle’s Vanguard became the second-largest asset manager in the world.

Performance stats have made it easier for investors to pick passive. Head-to-head comparisons are difficult, given that most active funds fulfill a different role than their passive peers (carrying more cash, for instance). But the broad data is encouraging. 

A Morningstar report from 2019 found that over the prior decade, just 23% of active funds managed to both survive and to outperform their passive peers.  ‘The likelihood and performance penalty for picking an underperforming manager tends to be greater than the probability and reward for finding a winner,’ the report found.

The performance illusion

The question is whether performance is sustainable, or if it just the result of a structurally driven bubble. 

It’s a query that’s been posed by investors such as Carl Icahn and Bill Ackman, the latter writing in a 2016 letter to investors explaining the prior year’s underperformance of  his fund: ‘large and growing inflows to index funds, coupled with their market-cap-driven allocation policies, drive index component valuations upwards’ meaning that index funds ‘are inherently momentum investors, forced to buy more as stock prices rise, magnifying the risk of overvaluation of the index components’; it is a phenomenon that ‘shares similar characteristics with other market bubbles’.

Of course, the S&P 500 is not actually a momentum index, but the point is that the index’s use as an investment portfolio produces odd effects. The index is market capitalisation weighted, meaning that the higher the value of a stock, the more its movements affect the value of the index. This may be sensible for a mathematical formula designed to answer this question: how did this asset class do in this given timeframe? But perhaps strange things happen when investors use it to answer a different question: where should I invest my money now?  

Vincent Deluard, director of global macro strategy at financial services grouoINTL FCStone, has pointed to the performance of Apple shares in 2019 as anecdotal evidence of the momentum phenomenon. The largest company in the world – and generally the largest component in many giant ETFs – rose 86% in 2019. The second largest, Microsoft, was up 55%.

To Deluard, the fact that the two largest stocks far outperformed the market is strong anecdotal evidence that flows into market cap indices are massively distorting asset values. 

The liquidity illusion 

Turning from index-tracking funds to ETFs more specifically, it is worth noting that they have another advantage beyond low fees: high liquidity.  

Trading throughout the day, generally at quite tight spreads and at a close correlation to the value of their underlying assets, they can serve as a meeting ground for investors of all different time horizons. Unlike closed-end funds, ETFs have an active built-in arbitrage mechanism that generally keeps the ETF price quite close to net asset value (NAV).

But critics appeal to common sense to make the case that something is wrong. Even a fund like the SPDR S&P 500 ETF will be far more liquid than nearly any of the index’s 505 stocks. But the situation would seem to be that much more dramatic for a fund like the popular iShares iBoxx $ High Yield Corporate Bond ETF, which trades with the ticker HYG and holds over 1,000 junk-rated issues.   

‘The high-yield market is just a keg of dynamite that sooner or later will blow up,’ and ETFs like HYG have ‘no liquidity behind them,’ Carl Icahn warned in 2015. ‘The average person that goes into this should basically be warned.’

In 2016, Allianz chief economic advisor Mohamed El-Erian tagged along, saying: ‘ETFs promise liquidity at reasonable prices. For example, it’s not clear that some of the ETFs in the high-yield space can actually provide that.’

A Moody’s report from 2019 struck a similar tone: ‘ETFs track not only the performance of their underlying assets, but also the liquidity of these assets… investors trading on the premise that ETFs are more liquid than their baskets may find that results fall short of expectations in a stressed environment,’ the firm wrote. ‘ETFs have experienced rapid expansion in a calm environment… [but]… extended bursts of volatility could reveal that ETF liquidity mirrors underlying market liquidity.’

Tested by a crisis

The time for that revelation would seem to be upon us. Stocks crashed as the Covid-19 pandemic ripped around the world, and the most common measure of volatility, the VIX, saw its highest close ever.  

And indeed, dislocations were seen. On March 11, HYG closed at a 3.3% discount to its net asset value (NAV), Bloomberg reported. The popular iShares 20 Plus Year Treasury Bond ETF fell 5% below NAV.  

More dramatic was the performance of the VanEck Vectors High Yield Municipal Index ETF, HYD. The previously placid junk municipal bond fund crashed as much as 38% in three weeks. At some points, it was 19% below NAV. 

However, this is a case in which the premise of the criticism suggests its rebuttal. ETFs like HYD and HYG are indeed far more liquid than their underlying components. That means they trade more. That means that their prices might be a better indication of the actual value of their underlying components than their NAVs. 

As GTS principal Reginald Browne flatly told ‘When fixed income ETFs trade at a 4% or 5% discount, it’s because you’re seeing stale prices in the underlying bonds… The ETFs are giving real-time price action, where the bonds are actually trading.’

When blocks of ETFs are created or redeemed, they change hands in exchange for the underlying securities. So in a sense, the ETF provides liquidity rather than saps it. 

This does not mean Moody’s is wrong. In a period of stress, the ETF cannot really be more liquid than the underlying – as its price will ultimately reflect the prices an investor believes they can get for the underlying. But it also doesn’t mean that the liquidity is illusory. 

Take the junk municipal bond ETF. Junk municipal bonds are inherently illiquid – they’re just not traded much. So we shouldn’t expect an ETF that is tracking said assets to be even-keeled at times when liquidity is drying up. But for someone who wants exposure to the junk municipal bond asset class, what’s the other option? If anything, one has a better shot at exiting and entering the HYD ETF at a fair price, compared to an esoteric junk-rated muni issue.   

It seems that, thus far, the most dire warnings have been proven fallacious. HYG and its peers have continued to be liquid through the crisis. And even if one doesn’t accept that NAV discounts are due to stale prices, with discounts of up to 5%, it can be argued that they have indeed continued to provide ‘liquidity at reasonable prices’ even amid a devastating crash. 

Performance anxiety 

Let’s turn from the generally index-tracking ETFs back to index funds writ large. Has their performance indeed been exposed as a bubble?

A Morningstar examination of the performance of active US equity funds during the time the S&P 500 was tumbling into a bear market (20 February to 12 March) found that their performance was more or less in line with passive. 52% of these active funds beat their index benchmarks during that time, and as a whole active US equity funds delivered an average excess return of just 0.16%.

Strikingly, just 17% of the funds tracked outperformed both in the crash and in the big 14-month rally that preceded it. And even the funds that did outperform during the crash are, on average, still underperformers going back to the start of the rally toward the end of 2018.

And as for Apple, that passive fund darling? From the S&P’s closing high on February 19 through March 20, the index has cratered 32%; in that same time, Apple shares are down 29%. Microsoft is down 27%. So far, the tech giants have not found the path down nearly as dramatic as the climb up. 

The idea that passive investing is a bubble, the beneficiary of herd buying that will quickly turn to herd selling once that bubble pops, does not seem to be borne out. 

Other critics have made a separate argument, suggesting that the speed of the crash has been exacerbated by the ease with which ETF investors could sell all their holdings in a flash. That may in fact be true. But does that really point to investor folly? Or does it instead highlight another benefit of the ETF wrapper? 

Looking forward 

Active managers have long said that the inexorable rise of low-cost, index-tracking ETFs would be proven a form of mass delusion in the next market crash. The crash has come fast and furious, but so far, many of those concerns have been unfounded. ETF liquidity has not dried up, and gaping chasms have not opened between ETF prices and the values of the underlying. Neither index funds nor their most popular components have crashed more swiftly than active funds. Indeed, one would generally have been better off holding them even through the prior 15 months, not to mention throughout the whole 11-year bull market. 

That suggests active managers cannot rely upon the crash to turn the tide and lead active management share to rise back above passive share. And it may indeed be worse than that.

‘The peak of active investing was in 1999,’ said Nick Colas, co-founder of DataTrek Research. ‘What happened after ’99? The answer is simple. The compounded annual growth rate for the S&P 500 had been 18%. For the 20 years ending last year, it was 6%. That’s why passive grew. It grew because of lower structural equity returns and the inability of asset owners to pay high fees for what became a much different return profile.’

Thanks to the crash, ‘those compounded returns will likely be even lower. Does that mean you go back to active, and pay more? No, it means you stay passive,’ Colas said.  

Then the bear market could actually accelerate the trend to passive, rather than stem it. 

But that doesn’t mean it’s time to throw in the towel. Perhaps it is not in a bear market, but rather in an even more buoyant and prolonged bull market, that active managers can expect to enjoy their revenge.


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