Unconventional wisdom: Investing in the age of passive: Market evolution or looming disaster?
Assessing the claims of passive investing critics.
Mentioned: VanEck Australian Equal Wt ETF (MVW)
Conventional wisdom is a byproduct of groupthink that presents solutions good enough for the average person while simultaneously not being right for any individual. You follow it at your peril. Each Monday I will challenge the investing norms that just may be holding you back from living the life you want.
Unconventional wisdom: Investing in the age of passive: Market evolution or looming disaster?
“He treated the world as something to be taken in block without pulling it to pieces to get rid of the defects.”
- Henry Adams (describing John Hay)
Last week I briefly touched on the ramifications of the increasing prevalence of passive investing. I cited a research paper by authors Hao Jiang, Dimitri Vayanos and Lu Zheng called Passive Investing and the Rise of Mega Firms. This struck a nerve with readers.
There is a good deal of angst about the rise of passive. Michael Burry of Big Short fame is a leading critic who believes the structural changes to the share market brought about by passive investing have set the conditions for a steep crash.
Other critics have blamed passive for the prolonged slump in value investing, increased market concentration, a breakdown of price discovery and for stifling innovation. It is only a matter of time before passive gets blamed for the obesity epidemic, how the Wallabies play and the price of avocados.
Criticising passive investing is nothing new. Fund Manager Alliance Berstein once equated passive investing with Marxism and a poster from a broker called it un-American (which was intended as an insult).
The rise of passive has undoubtedly changed the market. The scale of change has been too profound not to make an impact. But one can’t help but notice that most criticism comes from active fund managers who have been hurt by this shift.
Is the market different or distorted? Is this a disaster in the making?
I’ve been going through various academic studies to try to make sense of this debate.
The impact on the market
The uptake was slow after passive investment products were introduced in the 1970s. In 1993 passive funds investing in US stocks made up only 0.44% of the US stock market.
According to a study by Harvard Business School approximately 33% of the US stock market is currently passively managed when you include index funds, direct indexers and active managers who are closet indexers.
According to fund manager Maple-Brown Abbott, 26% of the Australian market is currently passively managed.
This was the context for the study I referenced in my previous article. In Investing and the Rise of Mega Firms the authors looked at S&P 500 data between 1996 and 2020 to try and measure the impact on returns from the growing popularity of passive investing.
In quarterly increments the authors compared investment flows into S&P 500 index tracking funds and ETFs with the returns of different shares based on their market capitalisation or size.
The authors calculated the return impact of a one-standard deviation increase in the amount of passive flows. A one standard-deviation increase means flows in a single period are 34.10% higher than the average over all the periods.
The following table shows how different categories of shares performed by size or market capitalisation.
As more money flows into passive investments it disproportionately has a positive impact on the returns of larger companies. Intuitively this makes sense but the study shows the actual impacts and reinforces the degree to which passive is changing share prices.
The impact is so great that the market rises if investors reallocate from active to passive without investing any additional funds.
These differences in returns add up over time. The study estimates that over the past 25 years a company in the top 50 of the S&P 500 received a return boost of 29% more than the index just due to the influence of the growth in passive investing.
There are numerous other studies showing similar impacts.
Implications of a distorted market
In a well-functioning market prices are set over the medium to long-term based on fundamentals. The degree and timing is up for debate.
The efficient market hypothesis claims that prices always reflect all available information. According to the hypothesis, as investors get new information share prices adjust immediately.
Most people – including me – don’t think the market is completely efficient. There are times when the market is more efficient than other times. Some markets are more efficient than other markets. It is never perfectly efficient.
As time passes prices come to reflect the fundamentals because profit-seeking investors try to buy undervalued shares and sell or short overvalued shares. Particularly for large, well-researched markets like the S&P 500 the majority of people believe the market is mostly efficient, most of the time.
The irony is that proponents of the efficient market hypothesis are also proponents of passive investing. If share prices always reflect all available information it is impossible to beat the market except by luck since there are no inefficiencies to exploit.
In highly, but not perfectly efficient markets, it is very difficult to beat the market. The data bears this out as most professional investors fail to beat the index.
Yet the study results show that the rise of passive investing has distorted markets and made them less efficient. If large firms are disproportionately benefiting from the shift of assets to passive their price changes are not purely reflective of fundamentals.
The study demonstrates this impact by pointing out that large shares have higher levels of idiosyncratic return volatility because of the growth of passive. Idiosyncratic return volatility refers to security specific factors that lead to changes in prices. This contrasts with market related factors that impact the price of all shares.
The idiosyncratic or security specific attribute that is driving this increase is the size of the companies. Knowing that the prices of large companies are distorted by passive inflows and outflows discourages the remaining active fundamental investors from acting on their views of these companies.
This is the lack of price discovery that passive critics like Michael Burry cite. The concern is that if buyers are just indiscriminately buying index funds with no regard to fundamentals on the way up, they will indiscriminately sell on the way down.
A market dominated by investors focused on fundamentals will stop falling when shares get cheap. Critics of passive contend this self-correcting mechanism won’t occur if asset flows from mindless panicking passive investors overwhelm the fundamental investors making sensible decisions.
What does all this mean?
I’ve spent the week reading academic studies on passive investing. I’ve been researching the views of passive investing critics including Michael Burry. I find the studies interesting and I’m drawn to contrarians - Burry fits the bill.
Yet academic studies and Burry sitting out the market with his estimated fortune of $300 million is not the real world. In the real world most people need to invest in the share market to build wealth. I’m one of those people.
The challenge that all of us face as investors is constantly hearing information and opinions that are often contradictory and difficult to apply to our personal circumstances. Here are my thoughts on how you should approach a market distorted by passive investing.
Will passive cause a market crash?
Some professional investors like to refer to individuals as the ‘dumb money’. The underlying rationale for the passive doomsday scenario is that mindless selling by stupid passive investors will turn a regular bear market into something much worse.
I don’t see it that way. You can be thoughtful and disciplined and invest passively. Both indexes and individual shares have numerous fundamental measures that can be used to make decisions. Markets are sliced and diced in countless ways and there are passive investment products tracking most of them.
Investors holding passive investments come in all shapes and sizes. There are individual investors and professional investors, short-term investors and long-term investors, people just starting out and people with decades of experience. This is not some uniform herd of lemmings willing to mindlessly follow each other off a cliff.
I think there is evidence to suggest that in a bear market a market capitalisation weighted index will fall more than it would without a preponderance of passive investors. That is just the maths of selling a market capitalisation weighted index.
But the study showed that market capitalisation weighted indexes have risen more than they would have without passive. Investing in shares means trading price volatility for high returns – how is this different?
Ultimately passive investors are far from dumb money. The data is clear on the approach to take to earn the highest return post fess and tax – invest passively. I think it is presumptuous to assume the people making the rational decision to invest passively are any more prone to panic than anyone else.
Should you change the way you invest?
Part and parcel of being an investor is having your approach and worldview constantly challenged. Often this happens in an overly sensationalist way which elicits an unwarranted sense of urgency.
When you feel this way I suggest going back to the basics of what you are trying to accomplish and the factors that will lead to success. Drastically changing your approach is almost never the right answer.
Passive flows are only one of many factors that impact share prices. I choose to focus on the factors that align an investment with my goal.
In my super I choose to invest passively. I think the market return will get me to my goal. I will just continue to invest as I get paid and ride the inevitable ups and downs of the market – even if they are a little more pronounced.
In non-retirement accounts I’m trying to build a growing stream of passive income. Passive flows only impact my approach from a valuation perspective. Valuations impact the current yield and how much future dividend growth I can buy for each dollar I invest.
The good news for me is that if passive has inflated the prices of the largest shares there are bargains elsewhere. In a recent interview in Barrons Columbia University Professor Abby Cohen made the point that the market capitalisation weighted S&P 500 is trading at 23 times forward earnings. Equal weighted, the S&P 500 is trading for 17 times forward earnings.
In the US I’ve been avoiding the largest companies while looking for shares that meet my investment criteria. In Australia I continue to buy the Van Eck Australian Equal Weighted ETF (ASX: MVW) because I think the dividend growth prospects outside the biggest companies are better.
I’m aware I likely won’t beat the market capitalisation weighted indexes if shares continue to climb. If the market pulls back I will probably outperform.
This is not a directional bet on the market – I’m just focusing on what matters to me and ignoring what doesn’t. I’m comfortable that over the long-term this is the best approach to achieve my goal of growing passive income.
Would we be better off without passive?
The academic study cited in this article was interesting and added some perspective as all of us try and navigate markets. But in the real world all that matters is how much money ends up in our pockets.
It is reasonable for an academic study to isolate a specific factor and show the impact. Yet the rise of passive has not occurred in a vacuum. Between 2005 and 2024, the average fee for all active and passive US funds and ETFs fell to 0.34% from 0.83%. This was largely due to the fee pressure from passive.
Many passive critics are the former recipients of those higher fees. Over the course of the study between 1996 and 2020 an investor earned a 9.46% annual return on an investment in the S&P 500.
A $100,000 investment would grow to $958,045 without fees. At the 2024 average fee of 0.34% an investor would be left with $886,357. If an investor paid the 2005 average fee of 0.83% the total would drop to $792,035. A passive investor would pay an even lower fee and likely get a better tax outcome than an active fund or ETF.
Each of us has decide if the distortion in pricing is worth these clear benefits. I know where I stand. I believe given the puts and takes passive investing has improved individual investor outcomes.
Final thoughts
I was listening to a biography on John Hay when I heard the quote I used at the beginning of this article. It instantly clicked.
We all want to pull apart good things to search for the defects – it is in our nature. But often we are better served ignoring the imperfections to keep moving forward towards our goals.
The rise of passive has changed the market. Change isn’t always bad.
Please share your thoughts by emailing me at [email protected].
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What I’ve been eating
Wonton noodle soup is a quintessential part of Cantonese cuisine. The Hong Kong version is like many great dishes and benefits from simplicity – hot broth, Chinese kale, egg noodles and prawn wontons. I hit my favourite spots in my recent trip including Maks and Tsim Chai Kee Noodle on Wellington Street and Mak Siu Kee in Causeway Bay.
The best experience was a new place for me called Shek Kee Wonton Noodles in Kowloon. The broth was rich and flavourful and the wontons were perfect. After a few drinks at a more reputable establishment than local dive bar Ned Kelly’s Last Stand I went a little heavy with the chili – such is life. .
