Most US stock trading these days is on some form of autopilot. A story from the Wall Street Journal at the end of last year estimated that roughly 85% of stock trades are via algorithms, passive investment vehicles or other strategies and models (for the WSJ story click here). This structure has a number of implications for financial markets. One major implication is that relative valuations between securities often seem to break down. A higher percentage of investor flows go into stocks which either comprise the most popular passive strategies, or which fit into popular factor investing strategies (eg momentum, low volatility, etc). A shrinking percentage of funds are invested based upon bottoms up, fundamental analysis. As a long term investor I like to let this be my friend - buy stocks which are cheap relative to their long term earning potential.
Michael Burry, of The Big Short fame, has recently been in the news describing a "passive bubble" and discussing investments in value stocks (often small cap value) ignored in this market, including US, Korean and Japanese names.
He also discusses the systemic risk - that investors are putting money into highly liquid instruments (such as some ETF's), which in turn hold less liquid underlying assets. This argument has been made before elsewhere, though usually in the context of vehicles which hold less liquid fixed income instruments. Burry makes the case that the same relationship holds for many stocks as well (for the Bloomberg article click here):
“The dirty secret of passive index funds -- whether open-end, closed-end, or ETF -- is the distribution of daily dollar value traded among the securities within the indexes they mimic."
“In the Russell 2000 Index, for instance, the vast majority of stocks are lower volume, lower value-traded stocks. Today I counted 1,049 stocks that traded less than $5 million in value during the day. That is over half, and almost half of those -- 456 stocks -- traded less than $1 million during the day. Yet through indexation and passive investing, hundreds of billions are linked to stocks like this. The S&P 500 is no different -- the index contains the world’s largest stocks, but still, 266 stocks -- over half -- traded under $150 million today. That sounds like a lot, but trillions of dollars in assets globally are indexed to these stocks. The theater keeps getting more crowded, but the exit door is the same as it always was. All this gets worse as you get into even less liquid equity and bond markets globally.”