Passive investment boom can cause a market bubble, but not in the stocks you expect

A trader on the New York Stock Exchange.

Brendan McDermid | Reuters

Passive investment critics claim that they inflate the prices of high-flying stocks like Amazon and create a bubble in those names. However, data collected by Ned Davis Research shows that the bubble can be formed elsewhere.

The company found that real estate and supply stocks are the two sectors that have benefited most from the increase in passive investment vehicles, including exchange traded funds. ETFs own more than 1[ads1]1% of the real estate sector and 9.8% of the utilities sector.

At the individual stock level, Tanger Factory Outlet Centers, a real estate investing company, has had nearly 32% of its available stock, or float, taken over by ETFs, by far the majority of all stocks.

Meanwhile, American States Water and the California Water Service Group have more than 23% of their ETFs flow. Washington Real Estate Investment Trust has nearly 23% of its floating share of ETFs. By comparison, Amazon and other major technological names have a much lower portion of their flow of ETFs.

Given which parts of the market have benefited most from the increase in passive investment, investors should keep track of much smaller companies such as Tangier for signs of a bubble.

"The Tanger Factory Outlets is the real crowded theater, where investors can be stepped and hurry for the exit," said Will Geisdorf, ETF strategist at Ned Davis Research, in a note. "Tanger Factory Outlet Centers (SKT) is the poster child for the passive bubble," he said.

Despite the huge ETF influx it has experienced in recent years, Tangier has been a massively underperforming stock. The stock fell more than 20% in 2017 and 2018. This year it is down more than 18%. By comparison, SPDR S&P Dividend ETF (SDY) – which owns 13% of Tangier's float – is more than 13% so far this year.

Geisdorf called Tangier the "outlet mall aristocrat" since that part of group companies – SDY components – that have raised the dividend for at least 20 years. But it won't last long, he says.

"Card sellers do not believe SKT will remain an aristocrat for a long time with 40% of the flyer kept short," Geisdorf said. If the pressure on brick and mortar retailers is intensified, "SKT's operating resources will come under pressure, making it harder for the company to continue increasing its yield."

The increase in ETFs has given investors a way to invest in stocks at a lower cost than investing in actively managed funds. However, there has also been concern about the formation of bubbles as market leadership has narrowed in recent years to just a few technology-related names.

Microsoft, Apple, Amazon and Facebook are some of the best performers in recent years and are most important in the S&P 500. However, ETFs own only a fraction of these shares. About 5% of Microsoft and Amazon's floating shares are owned by ETFs. Meanwhile, ETFs own 5.4% and 4.8% respectively of Apple and Facebook.

Perhaps one of the reasons why Tangier's shares aren't on investors' radars is because they're not as popular. Geisdorf points out that Tangier is not a top 10 stake in any ETF, so it does not appear on most of the fund's fact sheets.

Tangier is "stealth king of the passive bubble," said Geisdorf.

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