It's getting more difficult to freely trade stocks as investing turns into an 'extreme sport' — and Bank of America warns the worst is yet to come

ReutersFILE PHOTO: Traders and company executives gather for the Uber Technologies Inc. IPO on the trading floor of the NYSE in New York
  • The US stock market rarely faces hurdles for those looking to freely buy and sell shares, but a Wednesday note from Bank of America details how the S&P 500 index could face a liquidity crisis in the near future.
  • Nearly half of all US stock ownership is passive, and a widening gap between bid and ask prices is stifling potential trades.
  • Money managers are also shifting funds into long-term vehicles and short-term bets, retreating from the medium-term strategies that drove consistent liquidity in markets.
  • Even active investors are contributing to the problem, crowding into the index’s largest momentum companies at levels similar to “record Tech Bubble levels,” the analysts wrote.
  • Visit the Business Insider homepage for more stories.

US stock investors rarely face hurdles in freely buying and selling equities, but unexpected liquidity risks are mounting for the S&P 500 index, Bank of America analysts said Wednesday.

The key index’s components are increasingly bought by passive funds over active investors, leading stock fundamentals to take a back seat to fund flows. Nearly half of all US stock ownership is passive, BofA wrote, and the stocks held in such accounts have seen wider bid-ask spreads than usual. A wider gap between “buy” and “sell” prices quashes potential trades and suppresses stock liquidity.

Money managers are adding to the problem by loading up on short-term investments like algorithmic trading programs and long-term vehicles like private equity funds, BofA said. The shift dissolves many of the medium-term strategies that drove consistent liquidity in markets, they added.

“Investing appears to have turned into an extreme sport,” the team led by Savita Subramanian wrote in a note. “Similar to the hollowing out of the middle class within the US, we have seen a hollowing out of the medium-time-horizon investor.”

Even active investors are contributing to the liquidity squeeze. The group is piling more cash into a fewer assets, with their holdings in momentum stocks often overlapping. The S&P 500 is now “very tail heavy,” the analysts said, as the 10 largest members represent a quarter of the index. That level of concentration in momentum stocks is similar to the crowding seen at the peak of the technology bubble, the bank added.

Pension funds are copying broad move into passive assets, growing their exposure to illiquid investments to 24% today from 8% in 2006, according to BofA. Much of the funds’ passive holdings reside in private equity, and such assets are “relatively untested” for environments of increased capital costs or higher return expectations, the analysts said.

The analysts warned that, should private equity assets underperform, pension funds “may be forced sellers” of assets held in passive exposure to the S&P 500. Such a sell-off could tank the index and place massive downward pressure on the greater US stock market.

Now read more markets coverage from Markets Insider and Business Insider:

Nasdaq is poised to beat the New York Stock Exchange in IPOs for the first time since Facebook’s disastrous 2012 offering

The S&P 500 is on pace for its best year since 2013. Here’s a ranking of how each sector has performed in 2019.

5 top venture capital firms reveal their media predictions for 2020 and key trends they’re keeping a close eye on

Business Insider Emails & Alerts

Site highlights each day to your inbox.

Follow Business Insider Australia on Facebook, Twitter, LinkedIn, and Instagram.