14 October 2017
Markets are suffering from a serious case of passive aggression. Or at least that is what many now believe.
Passive investing - in which funds merely match an index and make no active attempt to choose stocks or other securities - has transformed markets over the past 25 years. In the US more than a third of stock funds assets are passive, while index funds dominate flows of new money into the market.
Passive investing can be done more cheaply than active investing, which requires spending on research and salaries. This gives it an advantage. And as institutions have come to dominate trading in markets, so the markets’ judgments grow more efficient. That makes traditional “active” management ever harder - few stocks are so obviously mispriced that investors can confidently expect them to beat the index. As more and more investors work this out, so passive investing has boomed.
Now that passive investors have become the giants they have morphed from the good guys to the bad guys. (rather like the giant companies of the internet). They now face questions over whether their scale is such that they are distorting the market.
The issue sharply divides opinion. The case against passive investing breaks down into two arguments. First, because passive owners will hold a given stock as long as it stays in an index, they have no incentive to take an active voice in the company, and no means to threaten the management. Thus passive management means weak stewardship and weaker corporate governance.
Managements are dubious. One chief executive told me: “We’d love to talk to the passive guys, they control 20 per cent of our shares, but they don’t want to see us.”
Beyond stewardship, another argument concerns price discovery. As index buyers are price-insensitive, the argument is that they thwart the process of setting an accurate price for a stock taking into account all known information.
In particular, as money flows into indexed mutual funds or ETFs, so an increasing share of those flows will go to those stocks that have risen in value. By trusting the price that the market has put on stocks, this argument claims, index funds overweight the stocks that are overvalued and underweight those that are undervalued. Active managers try to do the opposite.
Stocks have a tendency towards “momentum” - winners keep winning and losers keep losing. Momentum strategies in the US are having a banner year, with MSCI’s momentum index beating the market as a whole by almost 12 per cent. The equivalent value index, containing stocks that look cheap compared to their fundamentals, is lagging the market by more than 5 per cent.
This is serious. Misallocated capital has negative results for everyone in the economy. But is it true?
It is hard, therefore, to see how it can boost momentum towards the bigger stocks. Meanwhile, he says, the argument that indexing makes the market less efficient “implies that you are taking it away from the good managers”. Poor performance by active managers has been key to passive funds’ appeal, so this is hard to believe.
Against this, many in the market say that belief in a “Passive Put” is indeed affecting behaviour. The presence of the indexers, and the use of benchmarks to judge active managers’ performance, changes everyone’s behaviour.
The debate should continue. But like Facebook or
Copyright The Financial Times Limited 2017
(c) 2017 The Financial Times Limited