Passive Indexing and Float Manipulation

I have said multiple times in this blog that Bogleheads is one of my favorite investing forums — to read but never to post. There are many posters with deep understanding not jut in finance but also in many other areas of life willing to share their knowledge. But there is also a visible group with the “holier than thou” attitude for whom ignorance is displayed like a badge of honor. Not understanding something therefore choosing not to act is perfectly sane and prudent, and I’ll never hold anything against anyone for that. Not having the curiosity or the willingness to learn new things though is a fatal character flaw and a source of so much that is wrong in our society.

In this post I want to highlight two Bogleheads threads about whether passive indexing, as it becomes ever dominant, distorts markets and pricing, as well as if there are ways to take advantage of its dominance.

Our protagonist is user jbolden1517. I don’t know him (I assume it’s a he) personally but from his writings can surmise that he’s an investment professional and has been active since at least before the great financial crisis. I have an enormous amount of respect for him for no other reason than the amount of patience he displayed explaining things to a skeptical audience. jbolden1517 outlined a process of “float manipulation” where controlling shareholders can use index funds as a source of cheap financing:

User jbolden1517:

The real problem for indexers is float manipulation. If 70% of a stock’s float is going to be bought regardless of price it becomes incredibly profitable for a company to create float and sell shares to index funds (I’m including quasi-indexing and passive here) as a way to use index funds as a cheap source of financing. In a normal market, in CAPM’s theory investors are rationally pricing stocks based on their future discounted dividends using a discount rate that adjusts for risk. So under CAPM doubling the number of shares merely cuts the share price in half. Doubling the number of shares should have no impact on market cap. But of course index funds don’t rationally evaluate the future stream of dividends. Indexers hold a constant portion of any stock, buying or selling based on float not dividend prospects. So when the number of shares double they have to slowly raise they buy target till they get the shares back in balance. This is the same thing that happens to short investors in a short squeeze. They will end up paying far more than the company is worth.

User nedsaid finally getting the point:

So it is basically a game of now you see it, now you don’t. Those shares are technically float because B of A owns them, but not really. It sounds like what Company X does is over time release additional shares from its Treasury stock (stock it had previously purchased on the market reducing outstanding shares) to meet demand from the index funds. So Vanguard has to buy shares based on shares that are technically outstanding but not really because they are owned in synthetic fashion by B of A. What is being sold to the index funds is not B of A’s stock in Company X, but Treasury stock from Company X released incrementally to meet index fund demand.

The second thread contains discussions on inflows which is another way of looking at this crucial problem: what is the amount of trading due to passive index funds relative to those responsible for price discovery? Estimates today are that 35% of the total market capitalization is in index or closet index funds. Though this figure may not have any bearing on the composition of trade volume on any given day. According to this report from NYSC, for Q4 2016, U.S. ETF dollar volume represented approximately 29% of all consolidated tape issues in 2016. The vast majority of ETFs are cap-weighted indexers. We also need to keep in mind that there are also quant funds that “don’t read the earnings report” to use a phrase used by jbolden1517. He quoted a report from JPMorgan that 3/7th of the trading volume is from indexers, 3/7tg arbitrage and 1/7th fundamental. I have not been able to find a link to that report; however, the most recent memo from Howard Marks seems to confirm this:

Raj Mahajan of Goldman Sacks estimates that already a substantial majority of daily trading is originated by quantitative and systematic strategies including passive vehicles, quantitative/algorithmic funds and electronic market makers. In other words, just a fraction of trades have what Raj calls “originating decision makers” that are human beings making fundamental value judgments regarding companies and their stocks, and performing “price discovery” (that is, implementing their views of what something’s worth through discretionary purchases and sales).

Another piece of corroborating evidence can be found in the most recent Masters in Business podcast (Barry Ritholtz interviews Katie Stockton), there was a brief exchange starting around the 7:00 mark about the volume no longer being a good technical indicator which was attributed to index and quant funds.

My Own Thoughts

40% of my portfolio is passive, utilizing cap weighted index funds exclusively for the equity component. I see index funds as the most widely available, cost-efficient (in ER and time/energy) way of getting equity exposure. However, I also recognize their weaknesses which I discussed here. Lacking access to relevant data or studies, it was a purely mental exercise for me. So I was happy to have found a kindred spirit in jbolden1517‘s writing. In my own post, I was a little hazy on the “control share holder” aspect. An idea occurred to me after reading Eric Cinnamond’s The Passive Investor (PI) Ratio: a hedge/private equity fund could acquire a company with a high PI ratio and apply the float manipulation technique to use the index funds as its exit strategy.

In the spirit of intellectually honest exploration I want to present opposing views on the issue of trading volume attributable to fundamental discretionary traders. On one hand, there seems to be evidence to support the figure of 1/7th of trade volumes. It was probably 100% at one point in history, so 1/7th would be a big reduction. On the other hand, who is it to say it’s insufficient for price discovery? I don’t think anyone knows for sure. One other piece of data we may want to take into account is that the internal market correlation is a a low (source), although it could just be a sign of a top (source). In the end, I’m leaning towards there probably isn’t a big effect now but we’re probably closer to that point than most realize.

Defenders of passive indexing will rightly ask, what are the demonstrable ill effects of all these? The only possible answer is: very little to none, TODAY. It is no reason to be complacent, however. Imagine a real estate investor confronted with the malpractices in mortgage lending in 2005 and asking to see evidence of national housing price declines — there are real dangers in ignoring the warning signs.

I expect the migration to passive indexing to continue, consistent with my stock market projections. It’s a self-reinforcing cycle: more buy-at-any-price investors will prolong the bull market which tend to improve the relative performance of index funds over actively managed funds that limit their exposure, which leads to more passive indexers. While the trend is underway, it’s foolish to stand in front of it. At the same time, all the excesses and distortions will continue to build, providing opportunities when the trend finally turns. To me market timing in accordance with these trends is the most logical response.