The triumph of the blob: how passive investing could devour markets

We’ve always been fans of passive investing here at MoneyWeek. We’re not extremists about it – the debate can take on an evangelical overtone at times, but we still think that good active fund managers (mainly in the investment trust sector) can add a lot of value for investors. However, it’s also true that many active managers charge too much money, and that most also struggle to beat the market consistently over the long run. So index funds and exchange-traded funds (ETFs), which are a) cheap and b) can at least be relied upon not to hugely underperform the market, have proved a welcome innovation and a necessary competitor to a complacent fund management industry with an unfortunate tendency to take its customers for granted.

We’ve also generally been sceptical of claims that passive funds are distorting the market in any important way. That’s partly because, at the global level at least, the scale of passive investing is still hugely outweighed by the volume of assets under active management, and partly because the active management industry has a vested interest in attacking the sector. However, work by some analysts – in particular, Mike Green, chief strategist and portfolio manager at Logica Capital Advisers – as well as the increasingly significant size of the industry, suggest we may be reaching a turning point.

Price makers versus price takers

To understand how passive investing might be distorting today’s markets, let’s outline Green’s key insight before turning to the evidence that backs up his views. Let’s start with how active and passive investors behave – at least, in theory. An active fund manager buys a share based on assumptions about the future. These assumptions lead him or her to believe that the share price today is low enough relative to the company’s prospects, to deliver a worthwhile return.

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Note that you don’t have to be a value investor to adopt this strategy. Just about any price is justifiable as long as you make the right assumptions (eg, Tesla will be the Apple of self-driving cars by 2030). The point is that an active judgement is being made. So in a world that is dominated by active management, there is a level at which the average manager will deem a share price too high (or too low), and thus there is some sort of tether to the “fundamentals”, even if this gets extremely stretched at times of irrational exuberance or unjustifiable pessimism.

A passive fund, on the other hand, makes no judgement at all. As Green put it in an interview with Raoul Pal of Real Vision late last year: “It’s literally the world’s simplest algorithm. Did you give me cash? If so, then buy… Likewise, if you ask for cash, I’m going to sell and I don’t care where the price is.” In other words, in a world dominated by passive funds, the fundamentals are irrelevant, and no price is too high to pay (or too low to take).

As Chris Cole of Artemis Capital Management put it in a 2018 research paper, “think of passive investors as a drunk man at the bar and active investors as his sober guide”. If the drunk drifts too far from the path, his guide pulls him back on course. But what if passive investing dominates? Suddenly, “the drunk becomes so strong that his sober guide is not strong enough to influence him. Unencumbered, the drunk man can now move much faster in any given direction, right or wrong, but he is also more likely to get lost”.

Now, the standard objection is that this doesn’t matter. Passive investors are passive – they don’t make the decisions. As long as at least some active investors are doing the work of valuing stocks, then passive investors are just tagging along for the ride. Admittedly, passive is now a huge player in equity markets, with the US in the lead. In fact, in August last year, assets in US passive equity funds actually eclipsed those in active funds for the first time, with around $4.2trn in each. (Note that this doesn’t mean that passive funds own half of all US stocks – as of August last year, reports Bloomberg, US stocks held in passive and active funds combined represented less than a third of the total market). That said, passive advocates would argue that there are still plenty of active managers around to function as price-setters. The tipping point isn’t here yet.

Passive’s big regulatory advantage

But this view overlooks a key factor, according to Green. At the start of this year, reporters David McLaughlin and Annie Massa wrote a piece for Bloomberg in which they described “The Big Three” players in the passive fund management business – BlackRock, Vanguard and State Street – as “the most important players in corporate America”. Together, these three hold “about 80% of all indexed money”. Addressing US readers, and their workplace retirement plans, the writers argue that “when you clicked on the box to choose an index fund... you were also part of one of the biggest shifts in corporate power in a generation”.

In the piece, McLaughlin and Massa talk mostly about the governance and competition problems that may arise from passive funds owning huge stakes in so many of the world’s biggest companies (this was also a concern of the late Vanguard founder Jack Bogle – for more on that, see the box on the left). But they could also have been talking about a generational shift in investing styles. And this is what Green argues that we’re missing in the passive vs active debate – there’s a massive demographic split at work here.

The unarguable benefits of passive funds – that they’re cheap, transparent and pay you the market return – alongside the lobbying clout of the Big Three, has enabled them to thrive in a post-2008 environment where traditional financial institutions are deeply distrusted. Regulators have become so enamoured of passive investing that US employers who offer their staff long-term savings plans (we have Isas and Sipps; Americans have 401ks and IRAs) run the risk of being sued for underperformance, if they don’t offer low-cost passive funds as the default option. Understandably, no employer – especially outside of the finance industry – wants to take that risk.

As a result, the passive investment “revolution” is unevenly distributed across age groups. Older investors – those who are now retiring and unwinding their portfolios – are only about 20% invested in passive, says Green. But today’s working investors, the millennials, are almost 95% in passive. As Green said to Pal: “We make a lot of hype about things like Robinhood [but] the vast majority of money that they’re getting is actually just going into things like Vanguard target-date funds.”

In other words, the marginal money flowing into the market is almost all going into passive strategies, while the marginal money leaving the market (to fund baby boomers’ retirements) is coming out of active strategies. So you’ve moved from a market where the majority of money coming in is at least attempting to pay a reasonable price (a market that might not be as efficient as academia imagines, but is at least getting some guidance from the wisdom of crowds) to one where, as Green puts it, “whatever price is there, is the right price. We’ve never seen this type of buying pressure.” In short, “when the market is dominated by passive players, prices are driven by flows rather than fundamentals”. And that’s where we are today.

Where’s the evidence?

If this is correct, what would we expect to see happening? Liquidity Cascades, a paper put out this month by Corey Hoffstein of investment firm Newfound Research, suggests some indicators. The paper focuses on the bigger picture question of how both investor and central bank behaviour might have made markets more vulnerable to sudden crashes; but one key area he looks at is the rise of passive investing. Hoffstein argues that in a world where investors are selling out of active strategies (which differ from the index) and buying passive ones (which copy the index), then you’d expect to see selling pressure in smaller stocks that are less heavily weighted in indices but more widely held by active investors; and buying pressure in the biggest names in the index, in which a genuinely active investor is likely to be “underweight” (because if you want to beat the index you ultimately have to do something different to the index).

As Hoffstein says: “If sustained over time, this pressure could lead to the persistent outperformance of large-cap names versus small-cap names. This is precisely what we have seen since the early 2010s.” And if there’s a larger wave of money indiscriminately moving into indices as a whole, then you’d also expect to see stocks moving together more frequently, as a paper from the Bank for International Settlements noted in early 2018. And indeed, 2018 saw the first ever trading day on record when every single S&P 500 stock moved in the same direction.

At a wider level, growing domination by passive investing results in a shift from “convergent” to “divergent” investing strategies, notes Hoffstein. Value investing, for example, is a “convergent” strategy. It “is anchored to a level… investors sell when price is above the level and buy when it is below”. A “divergent” strategy instead aims to profit from “price continuation” – for example, with momentum strategies, you keep buying winners and keep selling losers, and there’s no such thing as “reversion to the mean”. In other words, as investors move from active to passive strategies, losing stocks simply lose more and winning stocks keep going up. Not only does this encourage more investors to move to passive funds, it also encourages active investors to shift to momentum strategies so as to avoid losing clients. This argument certainly goes some way to explaining why value investors have been enduring one of their worst periods of underperformance ever recorded.

Why does this matter?

There are two big implications. The obvious one, and the one that it’s tempting to focus on, is the bear case. If passive keeps going along this trajectory, the risk is that volatility explodes. Put very simply, if investors are increasingly all betting in the same direction at the same time, then liquidity becomes a problem, simply because if everyone wants to sell at the same time, then there won’t be any buyers to sell to – perhaps not at any price. That spells sharper, more violent market moves, and perhaps even 1987-style crashes.

However, the other big implication – and arguably the more pertinent one for bearish readers or those who have an old-fashioned attachment to things like valuations and fundamentals – is that there might be a lot more room to run here. As Green puts it in a paper for Logica (Talking Your Book About Value), “mean reversion only works when there is a discriminating rationality that can drive outrageous valuations lower… with the explosive growth of strategies that presume other investors are doing the hard work and that the only opportunity to benefit clients is to cut costs and just buy the whole basket, we have reached the inevitable conclusion that no one is standing in the way of insanity.”

Combine this with a central bank that, as Hoffstein puts it, is always willing to step in during a crisis to fix any “liquidity stress”, then traditional value investors may find that they are banging their heads against a brick wall for a lot longer than they’d ever have dreamed in their wildest nightmares. Who knows? The Federal Reserve’s newfound role as the buyer of last resort for just about everything might well one day extend to equities at this rate. We look at what this might mean for private investors below.

Index funds and ownership

The impact of passive funds on the structure of the market is rather esoteric. That’s one reason why far more attention has been paid to the risks posed by corporate ownership becoming more and more concentrated in the hands of a small number of passive fund groups.

As David McLaughlin and Annie Massa pointed out in Bloomberg earlier this year, about 22% of shares in the average S&P 500 company sit with the “Big Three” passive fund providers, compared to 13.5% in 2008. The providers say this doesn’t matter because they have no specific agenda and they don’t vote as a group.

But Harvard Law School professor Einer Elhauge argues that the real problem is that when big shareholders hold lots of companies in the same sector (eg, all the airlines or banks) then it reduces competitive pressure, because the owners don’t care if one does better than the other, as long as the sector as a whole does OK. In turn, that lack of competition means that consumers end up paying higher prices, and innovation and productivity suffer.

Passive fund providers of course reject these ideas, but as passive ownership climbs ever higher on the share registers of some of the world’s most significant companies, it’s very hard to believe that this won’t become increasingly controversial, especially in an age of “stewardship” and constant debate about environmental, social and governance (ESG) principles. Indeed, it seems far more likely that regulators will intervene in some way over these concerns than over the other issues raised.

What does this mean for your investments?

Is any of this a reason to stop using passive funds? Not at all. Firstly, the thesis could be wrong. These ideas make a lot of intuitive sense but there are other arguments (often involving central banks) that may explain value’s poor performance and rising correlations between stocks.

Secondly, even if the thesis is correct, passive funds are still a useful innovation and a good way to invest in specific countries or sectors – you can be an “active” investor and still use passive funds. The problem doesn’t so much lie with index funds as such, as with the impact their dominance has on a market.

So what does it mean for your investments? In general, if we’re facing a market that’s as likely to melt up as it is to melt down, then it’s important to diversify so that you have exposure to assets that can thrive in either outcome. That might seem like an obvious point but it’s still worth stating.

It extends beyond asset classes to investment styles too. At MoneyWeek, we have a value investing mindset – we like our investments to have at least some care for old-fashioned things like the fundamentals and as a result, we’ve been uncomfortable with the valuations of US equities for a long time.

However, in our model investment trust portfolio we’ve offset this tendency somewhat via our exposure to the tech-and-US-heavy Scottish Mortgage Trust (LSE: SMT). In short, don’t bet all your money on one outcome or one backdrop – regardless of your level of conviction, you may not be right.

So if you’re value inclined like us, find a decent growth manager to pick and choose the stocks you normally shy away from. And if you’re a FAANGs fanatic, don’t let that fool you into thinking that you can do without a bit of gold in your long-term portfolio.

The other point to consider is that if there is truth to this theory on the impact of passive growth, then it suggests something else – that perhaps there is room for a catch-up trade in the global markets where passive does not yet dominate to the extent it does in the US. That’s pretty much every other market in the world. Another good reason to be diversified.

Finally, don’t get too clever. A less liquid, more volatile market also implies a more fragile one. That means higher odds of blow-ups in exotic products. So never invest in any financial product you don’t understand, regardless of the returns it promises.