According to global equity manager Martin Currie, this dynamic was especially evident during the latest reporting season. Price volatility appeared elevated, but when compared with earnings revisions, it was clear that price movements far outstripped any changes in earnings.
Chief investment officer (CIO) Reece Birtles highlighted that the theme is distorting the ASX.
“The index flow distortion is most evident when markets are quiet and there are fewer information traders,” he said.
Datt Capital said it is plausible that price discovery is weakening in the Australian equity market, particularly for top-50 index constituents.
“Studies show higher volatility and correlation as passive ownership rises in global markets. Australians hold approx local ETF AUM of ~A$300 billion with the majority concentrated in large ASX constituents such as banks and miners which may amplify these effects,” CIO Emanuel Datt said.
“Skilled active managers add value to investor portfolios by mitigating concentration risk and providing a source of diversified returns. Appropriate manager evaluation is key and should consider important factors such as capacity constraints etc.”
Birtles said when the market sees new information on a stock, such as during results season, the overall volume of shares traded typically increases and the impact of pure index buying diminishes as it is overpowered by the trading based on the new information.
“This is what we have seen for several companies in the top 50 where their earnings were revised less than +/-2 per cent (what we would consider ‘in-line’) but had big share price reactions. Compared to prior periods, this is becoming more pronounced,” he said.
A concept that the firm introduced at the last reporting season was the impact of high index flow, an increasing dominance of index-aware strategies and the falling daily stock turnover of some of Australia’s largest index stocks.
“The willingness of investors to trade to match an index, regardless of price, is creating a persistent upward bias to price discovery for many stocks and greater volatility in these names,” Birtles said.
AMP chief economist Shane Oliver agreed that passive flows are reshaping price discovery.
“This can accentuate ‘bubbles’, say in a bank’s share price, which can then set up a bigger correction down the track,” he told InvestorDaily.
Oliver added that if passive flows continue to dominate, they could make the market less efficient in allocating resources around the economy, though he doubts they will ever completely take over.
Martin Currie also looked closely at Wesfarmers during the period, noting a significant price rerating despite subdued earnings. The company chose to return capital to shareholders rather than buy back shares, which Martin Currie interpreted as an acknowledgement of overvaluation.
The firm also drew a correlation between Wesfarmers this period and CBA last season.
“The number of Wesfarmers shares traded over time is falling; the stock has a high index weight; and for each dollar flowing into the index, we are seeing a higher percentage of daily traded turnover being driven by that high index flow,” Birtles said.
Similarly, stocks like CSL, CBA and James Hardie saw outsized price reactions to small updates. Normally, given their index weight, such moves would drag the broader market down. But this season, the market rose 3.1 per cent, highlighting how capital is simply rotating among other top-weighted index stocks like NAB, ANZ and Coles – regardless of news.
If “no information” volatility continues to rise, Datt Capital expects allocators to incorporate beta and inelastic-demand estimates into risk models.
“This will allow allocators to harvest predictable index returns utilising market information. We also anticipate a shift toward active management to reduce concentration risks,” Datt told InvestorDaily.
For active managers trying to generate alpha through bottom-up stock selection, he thinks it may become easier.
“[This is] due to valuation inefficiencies arising as a result of lower active manager participation in segments such as Australian small caps. This augments the value of active manager diversification as part of a broader investor portfolio,” Datt said.
As for whether regulators or market operators should step in, Oliver opined there’s no place for that.
“It’s just the reality of the market. Trying to regulate volatility sway will always end in failure,” he said.
Datt agreed, adding: “There is very little regulators can do to mitigate the unintended consequences of benchmark dominance. Whilst passive investments may appear attractive in benign markets, they tend to perform more poorly in choppy or declining markets versus active managers.
“Accordingly, we believe that investor behaviour is driven as a response to market forces and we are merely seeing one extreme at present.”
