Future Focus: Is passive investing killing the market?
What’s good for one may not be good for all.
Mentioned: Vanguard Australian Shares ETF (VAS), Vanguard MSCI Intl ETF (VGS), iShares S&P 500 ETF (IVV), BetaShares NASDAQ 100 ETF (NDQ)
I recently returned from my first trip to New Zealand. There is a peculiarity of our readiness as a nation to jump on a 24+ hour journey west to Europe while leaving an easy three-hour journey on the backburner. If you fall into this bucket, you’re missing out on delicious pies and scenic vistas - alps to rugged terrain to tropical greens. And lots of sheep. I thought they were kidding.
I don’t know if Garrett Hardin ever made it over to New Zealand but it would be akin to a fever dream of his most famous work. Hardin was an ecologist who was hated on both sides of the political aisle. He was a pro-choice ethno-nationalist. He became best known for popularising the tragedy of the commons. Simply put, he thought individuals acting in their own self-interest drained shared resources and ultimately hurt the broader community.
He used sheep as a parable to describe how this plays out. A community has a shared pasture – the commons – where the shepherds take their sheep to graze. Each shepherd gains the personal profit of adding another sheep to the pasture, but they only take on a fraction of the overgrazing of the pasture. They share the negative with the community but have the full benefit of the outcome. This means that it is always rational for the shepherd to continue to add sheep to the land until the pasture becomes unviable.
There are many examples of how the tragedy of the commons has played out in the real world. Overfishing, fast fashion, traffic congestion. Good for me, not so good for all of us. In the investing world, this accusation has been extended to the growing cohort of passive investors that are using markets to create wealth, without any sort of effort to participate in price discovery.
I am one of these investors. In a presentation to the Australian Shareholder’s Association last year I outlined my investment strategy, I lean heavily on passive ETFs.
During the Q&A session, an attendee commented on how I am contributing to the demise of the market and asked why I continue to promote others to follow suit. This question came from a genuine place of worry. The attendee was invested in a market that they believed was approaching an inevitable failure as more passive investors entered the market. The questioner believed that passive investors were fine in moderation, but the continued influx of investors blindly adding sheep each week will lead to a barren result for all.
Financial markets are full of situations in which decisions that appear sensible for individuals can contribute to outcomes that hurt investors as a group. Understanding this dynamic can help you recognise when the crowd is creating risks, why good investment opportunities can become bad ones, and why doing what everyone else is doing is not always in your best interests.
Are passive investors undermining the market?
The concern about passive investing is not entirely misplaced, but I think it may be misunderstood. There are two concepts that we first need to distinguish between – owning the market and determining the prices at which the market trades.
An index fund aims to replicate a benchmark. If a company makes up 5% of an index, the fund will generally allocate around 5% of its portfolio to that company. It does not need to decide whether the company is cheap or expensive. A passive investor follows the index without trying to assess the merits of each investment.
Conversely, an active investor might decide a company is overvalued and sell or undervalued and buy. Those decisions contribute to price discovery - the process through which investors’ collective assessments of a company’s value are reflected in its share price.
This is the sticking point for many investors worried about the influence of passive investing. If too many investors become indifferent to valuation there could be fewer trades taking advantage of, and in turn correcting, mispriced shares. If prices become less reflective of underlying fundamentals, capital could be directed towards businesses that do not deserve it.
In the US passive funds make up more than half of the market. In Australia, passive funds make up 26% of the market according to Maple Brown Abbott. Even if most investors hold index funds, prices are still influenced by the investors who actively trade. The greater the potential gap between a company’s price and its underlying value, the bigger the opportunity for an investor who can identify that discrepancy to profit. In simpler terms – if the incentive is there, someone’s going to take it.
I recently wrote about the changing composition of Australian investors’ portfolios. We’re seeing a lot more investors lean on passive ETFs as their core building blocks, while maintaining a satellite for active stock picking. It is much simpler to organise investors into their ‘passive’ and ‘active’ labels, but this is not the real world. Looking at actual investor portfolios shows active and passive investments coexisting. That keeps the mechanism of price discovery alive.
Other overgrazed investing paddocks
Imagine a company with strong growth prospects. Investors become increasingly enthusiastic about its future, and its share price rises. More investors notice the performance and buy shares, further increasing demand.
The key to a great investment is a good company at a decent price. We’ve got the good company but eventually, the price can rise beyond what even optimistic assumptions about future profits can support. This is where the second part of the equation begins to fail. When enough investors make the same decision without considering the price they are paying, the collective outcome can be disappointing.
Leverage is another example of a similar scenario. Borrowing to invest should be a carefully considered strategy by an individual who understands the risks and has the financial and constitutional capacity to deal with higher volatility. When investors collectively borrow more to buy the same assets, their behaviour can amplify price increases.
Eventually, a fall in prices can trigger margin calls, forced selling and panic selling. What appeared to be a sensible strategy for each individual becomes a source of instability when adopted on a large scale. Recently, we’ve seen this turn disastrous in South Korea with leveraged single stock ETFs.
The broader lesson is that individually rational decisions do not always produce collectively beneficial outcomes. Markets have been self-regulating, and the new flows into passive funds will not destroy the incentive for price discovery.
What we do need to be aware of is partaking in parts of the market where there are hints of irrationality and a disconnect from fundamentals. These are areas where investors enthusiastically engage in risk-taking.
What does this mean for your portfolio?
The tragedy of the commons is an interesting way to think about financial markets. The lesson isn’t to avoid whatever everyone else is buying.
If passive investing is the best strategy for you to achieve your goals, you shouldn’t abandon it because other investors are also using the same strategy. You should not feel a sense of responsibility for maintaining market efficiency by picking individual stocks. You can make sensible investment decisions without trying to solve every problem in the financial system.
Financial markets are not quite the same as a shared pasture. They are dynamic and complex. Prices and incentives are constantly changing. The act of buying an index does not necessarily consume a finite resource, and passive investors can benefit from the work undertaken by active investors without directly replicating it.
Active investors can benefit from the inefficiencies created by passive markets. Enjoy the symbiotic relationship and know where there is opportunity to profit – there will always be profit seekers.
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