Active fund managers who benchmark their performance against indices and ‘benchmark-aware’ active ETFs can contribute to rising market risk in much the same way as passive ETFs and index funds.
By mirroring index compositions, these ‘closet indexers’ contribute to rising stock correlations, which erodes diversification and increases market volatility, according to a paper titled Limits to Diversification: Passive Investing and Market Risk.
The research highlights how the rise of passive investing – namely through ETFs and index funds – can lead to higher correlations among stocks, meaning that stocks tend to move more in tandem.
This stronger co-movement between stocks weakens the benefits of diversification, since individual securities start moving more closely with the broader market.
As a result, during market downturns, portfolios may experience more significant losses due to this heightened correlation.
By extension, the paper highlights that performance benchmarking – and ‘closet tracking’ – encourage fund managers to mimic index compositions, which causes rigid demand for the same group of stocks found in popular indices.
This also makes many active funds less active than they appear.
The paper explained, “Performance benchmarking against indices leads stocks in the indices to be the preferred habitat for [institutional] investors.
“The common demand for stocks in the indices from these investors due to performance benchmarking can lead to excess price co-movements, via the same mechanism that we put forth above for explicitly passive funds.”
‘Benchmark aware’ or ‘index-plus’ have been the conduit for much of the the initial inflows into active ETFs in Europe. Among the most popular of these are the $10bn JPM US Research Enhanced Equity UCITS ETF (JREU), which employs a research driven, bottom up stock selection process and holds 253 stocks.
However, even the growing class of seemingly more high-conviction active ETFs have previously been scrutinised for resemblance to popular indices. While they boast smaller baskets of investments, these often contain large exposures to many of the large cap names that dominate indices covering their target markets.
Peter Sleep, investment director at Callanish Capital previously told ETF Stream, “With a beta of 1.02, [the Janus Henderson Tabula Japan High Conviction Equity UCITS ETF] appears to be risk-controlled. The top 10 stocks in the fund closely resemble the Tokyo Stock Price index.”
