Are Passive Investors Marching Off a Cliff?
Are Passive Investors Marching Off a Cliff?
As we pour more of our savings into indexes, we should beware that capital markets may be reaching a tipping point.
The return pattern of the newly-included S&P 500 member changes magically and quickly. It begins to move more closely with its 499 new neighbors and less closely with the rest of the market. It is as if it has joined a new school of fish.
—Jeffrey Wurgler, “On the Economic Consequences of Index-Linked Investing”
It’s official. As of year-end 2023, according to Morningstar, passive assets overtook active assets as a share of total assets in all US mutual funds and ETFs—including US equity funds, bond funds, and international equity funds.
For US equity funds alone, the Investment Company Institute says passive overtook active in 2021. Today it probably stands at around 60%.
To be sure, these are very fuzzy numbers. I’m aware of all the disclaimers that many investment pros insist upon, especially those who represent the big ETF triopoly—Blackrock, Vanguard, and State Street. ETFs, they say, can facilitate an active investment strategy, if by “active” you mean algorithmically complex. We now have “smart” ETFs (like the familiar “smart beta”) which can, in a nanosecond, sift through any number of parametric “factors” (hence, factor trading). The pros also remind us that all of these funds, passive and active, comprise less than a third of all shares outstanding. All the other shares, they imply, are still actively traded.
Well, I remain unconvinced. To begin with, the most heavily used ETFs remain pretty dumb: as in, dump my money, pro rata by market cap, into every ticker on this list. Yes, there are such things as smart ETFs, but smart does not mean active. To borrow from Keynes’ beauty contest metaphor, an algorithm is entirely focused on outguessing the beauty choices of other algorithms. Only an active human investor is able to evaluate whether, at the end of the day, somebody somewhere is likely to end up with a beautiful girl. Absent human judgment, active investment is impossible—since it is fundamentally (so to speak) untethered. Once “prices are set by the interaction of the passive sector’s mechanistic rules and trading algorithms, rather than the emotions and analyses of biological brains,” writes Vince Deluard at StoneX Financial, “the passive sector is creating the reality it was designed to mirror.”
Moreover, while passive algorithms can’t be active, that doesn’t mean that active traders can’t be passive. Far from it. If you take a look at all those “active” funds out there, you will find a growing share that are managed like tremulous index-tracking algorithms—humans in effect “mirroring” machines, to use Deluard’s turn of phrase. Not many Americans will long tolerate seeing their 401-k lag more than a few percent behind the Magnificent Seven.
And as for all those other, non-fund shares the Big Three pros like to talk about, most of these are low turnover; they are held by family offices, insurance companies, sovereign wealth funds, and such. They’re pretty passive—even inert—in most cases. To be sure, hedge funds and primary dealers are supposed to be active contrarians, and many are. But equity assets held by hedge funds and primary dealers represent less than 6% of all shares outstanding. And even the doughtiest hedge fund managers, after looking at their industry’s growing net withdrawals, have to think twice before embarking on some brazenly “uncorrelated” market strategy.
My bottom line is this. It doesn’t matter that we can’t assign an exact number to passive investing (as in: these funds are all active and these others are not). What matters is that a rising share of households are plowing their savings into index funds according to mechanical pro-rata allocation rules and that, in response, even active investors have started to behave as though passive investing rules the market—which of course means that it does in fact rule the market.
The Economist recently offered a couple data points highlighting this shift from active to passive. Over the last decade, the number of active funds that primarily trade large US firms has declined by 40%. And since 1990, despite a 9X growth in the market cap of the S&P 500, the number of analysts covering these firms has dropped by 15%. These declines, the Economist suggests, “means fewer value-focused soldiers guarding market fundamentals.”
From Active to Passive—How We Got Here
What structural forces have been pushing US markets toward passive investing over the decade or two—especially since the GFC? One force is Americans’ near-universal acceptance of the efficient market hypothesis, popularized by Harry Markowitz’s dictum that “diversification is the only free lunch in finance” and advertised by all of the early indexed mutual funds, especially Vanguard. By becoming a passive investor, you become a free rider, benefitting from the value-setting work of others, in the same way that I am a free rider every time I go into a grocery store and grab the first quart of milk I see, confident that some others shoppers are making sure that it doesn’t deviate more than a few pennies from its value. What can be more efficient than having someone else do the work for you? Who doesn’t love being a free rider?
On its own, the allure of market-efficiency probably would not be enough to tilt the markets so heavily toward passive investing. So now let’s add another structural force: The well-understood tendency of passive investing to “pile on value” to large market incumbents (because the largest firms are included in the most indexes and also because large firms are favored within indexes) combined with Americans’ growing belief that sheer size enhances a firm’s economic return and survivorship.
Whence this growing belief in the efficacy of size? From the evidence all around us. Larger size confers greater pricing power and higher markups in industries ranging from banking and airlines to food processing and pharmaceuticals. In technology, size holds out the promise of infinite returns to scale in winner-take-all markets. In our new era of industrial policy, favored by both political parties, big firms (and yes, big labor) garner the biggest political favors. And as for our growing dependence on the fiscal and monetary backstopping of market downturns, the words “too big to fail” pretty much sum it up. If you invest in AAPL, MSFT, and AMZN, and they drop by 50%, Fed Chairman Jerome Powell will be right there at your side with an emergency-powers press conference. If you invest in any three random members of the Russell 2000, and they go bust, it’s unlikely anyone at the Fed will even notice.
One further force pushing us in the direction of passive investing is generational. Back in the 1990s and 2000s, the rising young investors were Gen Xers—who made great active investors because they were natural contrarians. They grew up assuming that no one cared about them and that the future for most of them sucked, so they embraced taking big risks (in start ups and investing) by doing something different than most of their peers. That’s how they sought to beat the odds.
Since the GFC, the rising young investors have been Millennials. Their group motivations are very different. They grew up assuming that pretty much everybody cared about them and that they would be guaranteed at least a decent future. Their biggest FOMO worry is not being on the big train, ticket punched and fare paid, with all of their peers. So they have became avid “herd” investors, autopaying a (now default) share of their biweekly paycheck into every manner of passive index-tracking formulae, especially the vaunted “target date fund.”
I think Millennials understand perfectly well that, in our current Fourth Turning era, you need to belong to a large community to be safe. And the larger the community, the safer. By all investing (more or less) in an identical SPY portfolio, they either all prosper together or all go bust together. Either way, they won’t be envying each other. And better still, in the event they go bust, they can be confident that the nation will have to do something big—perhaps rewrite the rules of the game—to bail them out. After all, America can’t just stand by while nearly 100 million 20- and 30-somethings lose their life savings.
Xers once figured they’d be better off paddling their life rafts in separate directions. Millennials prefer to tie all their life rafts together. Millennials are surely on to something. Think about it. Who is most likely to get eventual relief: The student who himself (or whose parent) borrowed to put him through college, or the student who joined millions of others in borrowing from the federal government. The analogy to passive investing is obvious. There is safety in numbers—not just economic safety, but political safety.