The decadelong growth of cheap index funds is giving hedge funds an unexpected influence in setting market prices.
As investors hand more of their money to passive 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 fund manager Paul Singer said was "in danger of devouring capitalism." Almost $500 billion flowed 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?" asked Patrick Schotanus, an Edinburgh-based multiasset 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."
Market inefficiencies have created bouts of extreme volatility in recent years. From the pound's so-called flash crash in October — when the U.K. currency plunged more than 6% 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, said in a Bloomberg Radio interview in July. "They're just looking at price signals."
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 Baillie Gifford & Co. and Kames. "That's not great for the market because prices may be determined by short-term views."
This is not the first time that hedge funds' influence over markets has come in for criticism. Characterized as the Masters of the Universe in the 1980s, they'd taken a chunk of the business of old-money bankers by the mid-2000s with the sheer size of their investments.
Now, hedge funds are losing market share along with other active managers as their $3 trillion industry is pilloried for high fees and subpar performance by critics ranging from anti-capitalist protesters to billionaire Warren Buffett.
Mr. Singer, the founder of Elliott Management Corp., warned of the dangers of passive investing in a letter to clients last month, saying it damages markets because it doesn't discriminate: If bad companies attract investment along with good companies, he said, there's little incentive for them to create shareholder value.
Active money managers who contributed to the Financial Conduct Authority's recent study of the $9 trillion U.K. asset management industry echoed these complaints. They told the regulator that the popularity of passive investing risks allocating money to larger companies at the expense of smaller ones that are less represented in indexes.
They also warned hedge funds' involvement in price setting is "leading to larger divergences between prices and long-term values," according to the June report.
Yet critics of active management characterized the industry's complaint as an attempt to mask its failure to deliver value and retain clients in a market where unprecedented quantitative easing is damping price swings while sending stocks to record highs.
"It's the last roll of the dice," said Alan Miller, founding partner and chief investment officer at London-based wealth manager SCM Direct. Mr. Miller is a well-known campaigner against hidden fees in the industry.
"The active asset management industry is obviously under huge pressure because its performance has been disappointing for a long time," he said. "It's trying to cling on, with a feeble excuse to justify its existence."