Passive investing is immensely popular, with assets in passive funds having cleared US$13 trillion, globally. But can active investors take advantage of the new landscape this is creating?
Regardless of where an investor stands on the active versus passive debate, this new reality has shifted the overall market environment, revealing certain opportunities, said Ivan Cajic, global head of index research at Virtu Financial Inc., at an event hosted by CFA Society Toronto on Thursday.
“I’ve been covering the index space for about six years and I’ve observed an immense transformation in the space in a very short period of time,” said Cajic.
The flow into passive funds isn’t slowing down, he noted. Much of the growth during the past decade has been due to the natural growth in value of the assets in the funds themselves as equity markets have been on a lengthy bull run. However, even in 2018, a far rougher year for stocks, the amount of capital in passive funds still grew by US$1.5 trillion.
In fact, 45 per cent of North American stock market investments are in passive funds, although that number shrinks to 12 per cent when only looking at Canada, he said. However, when markets take so-called “closet indexers” like some mutual funds into account, the number of essentially passive holdings could be higher, closer to 20 per cent, he noted.
Within this environment, changes in the make up of indexes can dramatically push certain stock prices in different directions. For active equity traders, this could be an opportunity to take advantage of significant price action.
“Periodically, usually quarterly, indexes will undergo what are known as rebalances. And the purpose of these rebalances is to ensure that index continues to meet it’s investment mandate. They could be something as simple as re-weighting for existing constituents or it could be a complete reconstruction of the index with new companies being added and existing companies being removed.”
He demonstrated the potential to anticipate significant price movements by showing what happened to certain stocks when they were added or removed from key indexes. The S&P/TSX 60 index added Shopify Inc. to its ranks earlier this year, which caused the stock to jump around 10 per cent over the week, off the back of demand from portfolio managers who needed to rebalance to include it in funds following that index.
Inversely, getting removed from an index can have a detrimental effect on a company’s stock price. For example, First Mining Gold Corp. was removed from the MVIS Global Junior Miners index because it failed to meet the continued eligibility criteria. The index announced First Mining would be removed and the next business day it opened down 10 per cent and then dropped further in a week where the index posted positive returns.
With both these examples, trading volumes also skyrocket, he noted. “This is real, transactable liquidity that everybody can take advantage of.”
By analyzing the criteria that indexes use to determine which stocks to include, investors can start to learn what changes to the index are more likely than others, he said. “Since most indexes are constructed using strict rules based methodology, it’s possible to take that methodology, replicate it, construct a model, use an investible equity universe and intelligently identify companies that are potential candidates to be added or removed.”