Do tracker funds distort markets?

If enough investors were in passive funds, markets wouldn’t work properly. Is that where we are now?

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At MoneyWeek, we are fans of passive investing. Passive funds give investors a cheap, easily accessible way in which to track almost any stockmarket they wish. You won't beat the market, but then most active fund managers won't either. So if you can't be bothered to do the research needed to maximise your chances of picking a decent active manager (and then stick with them when they inevitably test your resolve with a period of underperformance), then passive is almost certainly the way to go.

Lots of people agree. Which is why the lion's share of new money flowing into the market has gone into passive vehicles rather than active ones. This trend is particularly pronounced in the US, which, as usual, is somewhat ahead of the game when it comes to innovation and private investors. However, there does come a point logically where a market can have "too much" passive investment. If no one is using their judgement to pick stocks, then the market can no longer function as a means to allocate capital efficiently. Yet we have no idea where that point lies, and it's quite possible that it's a largely theoretical issue and it certainly shouldn't put you off passive investing as an individual.

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However, recent research from Vincent Deluard of INTL FCStone, cited by John Authers in the Financial Times, suggests that the point of "peak passive" might be near (or past) in the US market. How did he come to this conclusion? Deluard took the 3,000 largest US stocks (by market capitalisation) and then looked at how many different indices owned them. After controlling for size (because obviously, the bigger the stock, the more indices it will appear in) he found some evidence that the more indices a stock was featured in, the more expensive it was. While it is hard to distinguish cause and effect here (do indices buy stocks because they are expensive, ordo stocks become expensive because indices buy them?), this is a glimmer of the potential distortions that many have warned of for several years now if passive investing is blindly funnelling money into a few key stocks, then those stocks are likely to become overvalued in the process.

On the other hand, this is music to an active manager's ears. If shares become overvalued because of passive funds, then that should mean there's potential for gains in the stocks that have been left behind. And, according to Deluard, that's the case since early 2016, "index dropouts have beaten the S&P 500", and in 2017, "stocks least loved by index providers performed better than the rest". Of course, if the idea takes off, the release of an "under-indexed stocks" index probably won't be far behind.

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