The decade-long growth of cheap index-tracking funds is giving hedge funds an unexpected influence in setting market prices.
As investors hand more of their money to passive fund managers and active stock pickers get sidelined, hedge funds’ heft is being magnified. Active fund managers warned Britain’s financial regulator that increased index-tracking is distorting markets by allowing hedge funds with “short-term” outlooks to set prices that don’t reflect fundamentals.
The impact on pricing is another consequence of the surge in passive investing, which hedge funder Paul Singer said was “in danger of devouring capitalism.” Almost $500 billion flowed from active to passive funds in the first half of 2017, and index followers have grown to account for more than a third of all assets under management in the U.S.
“As more and more people sign up to passive, will there be enough true price discovery?” said Patrick Schotanus, an Edinburgh-based multi-asset investment strategist at Aegon NV unit Kames Capital, which manages about $59 billion from the U.K. With fewer firms participating, there’s “the risk that inefficiencies creep into the market.”
Flash Crash
Market inefficiencies have created bouts of extreme volatility in recent years. From the pound’s so-called flash crash last October -- when the U.K. currency plunged more than 6 percent in just two minutes -- to the sudden dive in U.S. Treasury yields two years earlier, such events are becoming more common as liquidity dries up amid the rise of computerized trading and the pullback of traditional market makers.
The sidelining of active money managers is particularly perilous because traders had come to rely on them to provide liquidity as traditional market makers are weighed down by increasingly onerous banking regulations. When these fund managers lose market share, prices become more closely aligned to what others -- such as hedge funds -- are willing to buy and sell at.
It “can’t be a good thing” when short-term investors such as hedge funds have more influence on prices “because they are not looking at the fundamentals of the economy,” James Athey, an investment manager at Aberdeen Asset Management Plc, said in a Bloomberg Radio interview in July. “They’re just looking at price signals.”
‘Short-Term Views’
Hedge funds are “looking at trading situations where they can make money today, or this week, this month,” said Alistair Haig, who teaches finance at Edinburgh University and has worked at Scottish investment firms Baillie Gifford & Co. and Kames. “That’s not great for the market because prices may be determined by short-term views.”