To those who have made it to the conclusion of this series, I salute you.
We’ve covered a lot of ground in the last eight posts, but hopefully now you’ve reached the end you have a more evidence-based opinion on why it’s unlikely that passive investing causes bubbles.
I appreciate there’s been a lot of evidence and arguments to process, so I’ll use this post to provide a summary of what we’ve seen so far.
This post brings together the eight previous posts into a brief reference point for those wishing to refer back.
Because more and more investors are choosing to invest passively, there must be a bubble brewing in the stocks passives are buying. Because passives buy the market in market-cap weights, passives are pushing up the prices of the largest stocks in the index, ignoring the stocks’ fundamentals.
Sharpe’s Arithmetic of Active Management (post #1)
- Sharpe’s Arithmetic of Active Management starts by stating that the market must represent the combined portfolios of all active and passive investors. By its definition, the market represents the combined portfolios of all investors.
- If this is true, then if the returns of the passive investor and the returns of the market are the same (which they always will be, before costs), then the returns for the active investors, in aggregate, must equal the returns of the passive investors, before costs.
- This shows that active investors, in aggregate, must hold the same portfolio as passive investors.
- Flows into passive products can therefore have no impact on relative prices. Passive investing is simply a cheaper way of accessing the market than via active funds.
- Because passive investors are buying the whole market, flows into passive vehicles have no impact on relative valuations.
The market share of passive investing (post #2)
- At the highest estimates, passives constitute around:
- 20% of the global equity market,
- 2% of the global bond market,
- 4% of the global high yield bond market.
- Passives have too small a share of the global markets to impact on price discovery. They’d likely need to represent over 90% of the market before affecting prices.
Is passive investing setting prices? (post #3)
- Passives account for somewhere between 1% and 10% of primary market trading volume – according to research from The ICI, Blackrock, Vanguard, Morningstar, Charley Ellis, and S&P Dow Jones.
- Even under extremely conservative assumptions, passives would have to approach 90% of market AUM to exceed 50% of trading volume.
- Buy-and-hold passive investing is equivalent to removing shares from the market. Walmart only have 50% of their shares actively traded, yet nobody is concerned that Walmart shares aren’t priced properly.
- Even in the high yield bond market, passives account for somewhere between 2% and 6% of primary market trading volume.
- Given that trades placed by active stock selection represent the vast majority of trading activity, active management remains the critical driver of price discovery.
Source: S&P Dow Jones
Passive investing and market crashes (post #4)
- There’s no relationship between the rise of passive investing and bear markets.
- There’s no relationship between the rise of passive investing and market volatility.
- Bubbles (and therefore crashes) are an inevitable part of markets, and are not caused by any single investment strategy or vehicle.
- Even if passives were affecting prices (which we’ve seen they aren’t), they would likely be supporting markets during a crash, rather than magnifying the selloff.
Is passive investing making the market more concentrated? (post #5)
- It’s always the largest stocks which drive the market – that’s how capitalisation-weighted indices are designed to work. The market is a capitalisation weighted index. This has nothing to do with passive investing.
- If you think back to Sharpe’s Arithmetic of Active Management, it shows that active managers create the market portfolio. The idea that passive managers, who merely track the market created by active managers, are changing the composition of the market and increasing its concentration in a few stocks doesn’t make sense.
- The evidence shows that market concentration has remained largely the same since the 1980s. It’s actually become markedly less-concentrated since the 1960s – 20 years before passive investing existed. The rise of index investing hasn’t caused the market to become any more concentrated, “narrower”, or helped to fuel a bubble in a few large stocks.
Are large stocks getting larger? (post #6)
- If passives were inflating prices, we’d see little change in the membership of the top 10, and similarly little change their relative rankings. We’d also see far fewer negative returns among the largest stocks.
- Starting by examining the largest stocks in the world (those most accused of being distorted by passives), we’ve seen that:
- Membership of the top 10 largest stocks is constantly changing,
- The relative rankings within the top 10 are also constantly changing,
- There is still large dispersion in returns amongst the top 10,
- There are still huge drawdowns within the top 10 stocks,
- Outside of the largest stocks, there is still considerable dispersion, showing no correlation with the rise of passive investing,
- Large individual stock selloffs still occur both within the top 10 stocks and in the wider market.
- These findings all indicate that actives are clearly still responsible for setting prices. Passives, being price takers rather than price makers, are simply accepting the prices that actives are setting. It’s hard to see how they can be blamed for distorting the market.
Where are all the outperforming active managers? (post #7)
- Index investing is a simple, rules-based approach to investing. With huge flows into such a transparent and rules-based strategy, it seems reasonable that if such a strategy were changing the market, active managers would be able to exploit the strategy’s transparency and rules-based approach to increase their chances of outperforming.
- If passive investing was in fact causing glaring inefficiencies, then sufficient profits would exist to motivate active managers to take advantage and outperform.
- We can see from the ‘Active vs Passive’ section of this blog that this isn’t happening. The overwhelming majority of active managers continue to underperform their benchmarks.
- The lack of outperformance from active managers is strong evidence that passives aren’t distorting the market.
Why passive investing is increasing market efficiency (post #8)
- Despite the claims that indexing is responsible for creating bubbles in the market, it’s very likely that just the opposite is true. Passives are very likely helping to increase market efficiency.
- The availability of passive options has provided a strong alternative for those disappointed with their active funds. The flows from active into passive are most likely to come from the least-skilled active managers – including closet index trackers. By removing the least skilled active managers from the market, passive investing is helping to ensure the market is populated with skilful active managers, and therefore increasing its efficiency.
- By removing the least-skilled active managers from the market, the rise of passive investing makes active management an increasingly difficult game. Those skilled active managers who remain are more likely to be competing against other skilled managers. This further strengthens the argument for passive investing, as outperforming in a market with only skilled active managers becomes a progressively more difficult game.
- Not only are passives helping to increase market efficiency through weeding out the poor active managers, they’re also helping by providing a supply of much-needed securities for short sellers to borrow. Stocks can now be borrowed more easily, at lower prices, and for longer time periods – all of which help keep markets efficient.
The power of incentives
Indexing is an odd risk to worry about.
It’s bizarre that some people have a problem with investors shifting money into funds that:
- Save them money in fees,
- Have lower turnover and trading costs,
- Have low minimum investment requirements,
- Beat the majority of actively managed funds over the long-term,
- Are simpler and easier to understand than most active strategies,
- Are easier to stick with than most active strategies,
- Require less monitoring, decision-making, and therefore less time, and
- Require less monitoring, decision-making, and therefore less stress.
Much of the negative press around indexing is more to do with career risk in the investment management industry than genuine concern.
As regular investors are becoming more aware that the seductive narratives used by active managers might not translate into desired outcomes, the active management industry has found itself under intense pressure to reduce fees.
Using baseless arguments to discredit indexing is an ethically dubious way for the industry who claims to be acting in the best interests of investors to protect itself against margin compression.
Is it possible that the stock market could become a bubble again?
Of course. There will always be bubbles.
Are index funds perfect?
They’re boring. Nobody will form a tight circle around you at the pub, as you regale your rapt listeners with tales of Vanguard’s 0.07% expense ratios.
They won’t make up for a low savings rate. As we saw in this post, the amount you invest has a far larger impact on your future portfolio value than your investment returns. Choosing passive vehicles over active won’t move the needle if you don’t save enough.
There’s also really no such thing as purely ‘passive’ investing. The Global Market Portfolio is un-investable, and the indices which passive funds track can be subjective.
Performance-wise, they don’t give you the thrill of watching your portfolio smash a benchmark.
They give you all of the upside of the market, but also all of the downside.
Yet despite passive investing’s flaws, it’s important to be able to tell the genuine criticisms of passives from the yawping of self-interest.
Hopefully this series has provided some context for those worried about indexing’s effect on the market, and gone some way towards dispelling the myth that passive investing causes stock market bubbles.