Is passive investing causing a bubble?

Is passive investing really worse than Marxism?

Is it creating a ‘frightening risk for markets’?

Or are the concerns around passive investing nothing more than trumped-up fearmongering?

This series begins by examining one of the most fear-inducing (and therefore one of the most persuasive) claims thrown at passive investing – that the rise of passive investing is fuelling a stock market bubble.

I’m not selling either active management or passive management on this blog, so I thought it might be useful to take an independent look, and examine the question in more detail.

For clarity, and due to the volume of evidence, I’ve split the article up into sections:

The claim: Passives are causing a bubble

What is a passive investment?

The evidence

1. Sharpe’s Arithmetic of Active Management
2. The market share of passive investing
3. Is passive investing setting prices?
   
4. Passive investing and market crashes
   
5. Is passive investing making the market more concentrated?
   
6. Are large stocks getting larger?
   
7. Where are all the outperforming active managers?
   
8. Why passive investing is increasing market efficiency.

Summary

Without further ado, let’s dive straight in and start by taking a look at the claim itself.

The claim: Passives are causing a bubble

This is by far the most common argument against passive investing I’ve seen, and it goes like this: because more and more investors are choosing to invest passively, there must be a bubble brewing in the stocks that passives are buying. Because passives buy the market in market-cap weights, the largest stocks in the index are having their prices pushed up, and the smallest stocks are having their prices pushed down.

In the words of Timothy O’Neill, the global co-head of Goldman Sachs’ investment-management division, “essentially every new indexed dollar goes to the same places as previous dollars did. This guarantees that the most valuable company stays the most valuable, and gets more valuable and keeps going up. There’s no valuation or other parameters around that decision,” he said. “The result will be a “bubble machine”—a winner-take-all system that inflates already large companies, blind to whether they’re actually selling more widgets or generating bigger profits”.

Some of the headlines have been particularly eye-catching, too:

Source: Bloomberg

Source: Bloomberg

Source: The FT

Source: CNBC

These fears aren’t anything new. Legendary hedge fund investor Seth Klarman included his thoughts on indexing in his book Margin of Safety, published in 1991:

“I believe that indexing will turn out to be just another Wall Street fad. When it passes, the prices of securities included in popular indexes will almost certainly decline relative to those that have been excluded. More significantly, as Barron’s has pointed out, “A self-reinforcing feedback loop has been created, where the success of indexing has bolstered the performance of the index itself, which, in turn promotes more indexing.” When the market trend reverses, matching the market will not seem so attractive, the selling will then adversely affect the performance of the indexers and further exacerbate the rush for the exits.”

 Source: Ben Carlson

Let’s start with what’s correct about these statements.

In one respect, the critics are right – passives have been taking huge flows away from active management. It’s a seismic shift in the investment management landscape, and one that shows no signs of slowing down.

With charts like this, I’d be scared if I was trying to fight against passive investing too:

Source: Investment Company Institute

For those with an axe to grind against passive management, the attacks are at least understandable. But even amongst those with no vested interest in attacking passives, there’s still a worry that passives are pushing up prices.

In a 2018 survey of pension schemes, while 80% of respondents claimed they were going to increase their allocations to passives in the next 10 years, 68% worried that passive funds rely on yesterday’s winners and inflate valuations.

The logic sounds persuading at first glance. But how true is it really? Are stocks really marching inexorably upwards to passive investing’s drumbeat? Is the rise of passive investing causing a ballooning systematic risk, inflating the fallout for when it eventually pops?

The evidence shows that the answer is, almost definitely, no.

But before we dive into the evidence, it’s useful for all of us to be on the same page. I’ll do a quick explanation for what I mean by ‘passive’ investing, as it’s a term that means different things to different people.

What is a passive investment?

For the purposes of this article, when I’m talking about passive investing, I’m meaning buy-and-hold investing into a global, market-cap weighted index-tracking vehicle (ETF or index fund).

Some say any index fund or index-tracking ETF is a passive investment, but we’ve seen in this post that it’s not true. Many people select index-tracking vehicles to gain access to a particular sector or geography of the market – like the healthcare sector, or the UK market for example – and actively trade the ETF based on whether they think the exposure is a good investment. These are active decisions using passive vehicles.

This post showed that while ETFs are usually thought of as passive vehicles, the reality is that most ETFs are actively traded – they are passive vehicles being used in active strategies. The SPDR S&P 500 ETF ‘SPY’ is the most actively traded security on the planet. Over the year ending 30th April 2017, the average holding period for SPY was 15.4 days:

Source: Morningstar

Despite it being a passive vehicle, an asset with a holding period of just over two weeks cannot be thought of as passive. Active allocators are using ETFs to gain broad exposure to specific markets in their active strategies, and are trading them based on their preferences for regional exposure.

So let’s not confuse a passive strategy with an active strategy, despite many passive vehicles being used for active purposes.

Passive investing, in my book, is both using passive vehicles (market-cap weighted global index trackers), as part of a passive strategy (buy-and-hold).

Now we understand what is passive and what isn’t, let’s start examining the claim that passives are causing a bubble, and having a look at the evidence.

1. Sharpe’s Arithmetic of Active Management

Sharpe’s Arithmetic of Active Management is an extremely strong way to think about the structure of markets.

To understand the concept, you can think of the equity market as being owned by two kinds of investors: a) market cap indexers, who own every equity in the market in proportion to its market capitalisation, and, b) active managers, each of whom owns a portfolio of equities that they believe will outperform.

We can see that while each active manager will own a portfolio that diverges from market cap weights, combining all the portfolios of all the passive managers and all the active managers in aggregate is, by its very definition, the entire market.

If the market represents the combined portfolios of all active and passive investors, 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.

As William Sharpe explained in his seminal 1991 note (found here – very short and definitely worth reading in full):

‘Each passive manager will obtain precisely the market return, before costs. From this, it follows (as the night from the day) that the return on the average actively managed dollar must equal the market return. Why? Because the market return must equal a weighted average of the returns on the passive and active segments of the market. If the first two returns are the same, the third must be also.’

Both the portfolio representing the aggregate of all active managers and the portfolio of index-trackers are the same capitalisation weighted ‘market’ portfolio. Therefore, the returns to active investors, on average, and the returns to passive investors must be the same, before costs.

Once costs are factored in, passive investors must come out ahead of the average active investor, due to the active investors paying higher fees.

The chart below shows how the logic manifests itself in the real world. Historical performance has been consistent with the theory, presenting as a bell curve of both positive and negative manager returns, centred on a value of slightly below zero.

Source: Vanguard

Because active funds in aggregate hold exactly the same portfolio as all the indexers, it doesn’t make sense that flows into passive funds should distort the market.

All that cash flowing into the market could have gone into active funds or passive funds – it makes no difference. As we’ve seen, they’re the same portfolio. The only difference is that investors putting their cash into active funds would be paying more for the privilege.

Furthermore, because both passive and active investors are buying the whole market, it’s impossible for flows into either to distort the relative valuations of the index constituents.

Let’s take an example.

Suppose an investor makes a £1,000,000 investment into an MSCI All Country World Index (ACWI) ETF – this is a global index-tracking ETF which is close enough to represent ‘the market’ for our purposes. This investment means the investor is purchasing every stock in the MSCI ACWI Index. Microsoft is the largest stock in the world as at the time of writing, representing about 3% of the MSCI ACWI. Therefore, £30,000 of our investor’s £1,000,000 goes into Microsoft. The net result of the transaction is that Microsoft was 3% of the index before the investment, was 3% of the amount purchased, and is 3% of the index after the trade. The flow of funds into the MSCI ACWI ETF had no impact on the stock’s relative valuation – because the invested cash bought all stocks in the index according to their relative weight.

This by no means demonstrates that Microsoft is fairly valued. It may very well be overvalued. But if it’s overvalued, it got to be that way because more active investors increased their allocations to Microsoft, not because of increased flows into the market.

I used an example of a passive fund here, but as we saw with Sharpe’s arithmetic, flows into active funds, in aggregate, would have exactly the same effect on relative valuations – none.

Where flows would impact valuations would be if higher flows were seen into a particular segment of the market. If all active investors thought healthcare stocks were a good bet, and increased their collective allocations to healthcare funds, then healthcare stocks would become more expensive relative to the rest of the market.

But as long as flows are being applied to the whole market – as is the case with passive investors – then relative valuations cannot be affected.

Summary

• Sharpe’s Arithmetic of Active Management shows that active investors, in aggregate, must hold the same portfolio as passive investors – both hold the market.

• 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.

Part 2 in the series looks at the size of indexing relative to the rest of the market, and whether it’s large enough to create price distortions.

Further reading

William Sharpe: The Arithmetic of Active Management

Vanguard: Setting the record straight: Truths about indexing

S&P Dow Jones: The slings and arrows of passive fortune