Passives Have Eaten The Market

Right so this is one of the most common arguments that gets chucked out against index funds.

When a product comes onto the market that is a) significantly cheaper than the incumbents and b) largely generates better outcomes - you have to expect some smoke from the old boys.

The growth of passive/index/tracker investing over the past couple of decades has been material. “Tracker” strategies have gone from a fairly niche product in the corner of the market, to the foundational bedrock of many an investor’s portfolio.

And for those who argue against index investing, this growth will surely have dire consequences someday.

These strategies are price agnostic and therefore the argument goes, as tracker strategies become bigger and bigger they will drive up the price of the largest (and arguably most overvalued) stocks in the index as they are forced buyers of these names.

The market becomes unbalanced, breaks down and then the world ends (or something).

This argument would seem to hold some water on the surface at least, as the rise in passive investing over the past decade has coincided with rising stock market concentration in the biggest names.

But as we have seen before in these pages a) stock market concentration is nothing new and b) rising concentration is not in and of itself a bad thing - quite the opposite.

There also remains the fact that correlation and causation are two different things. Just because rising concentration has taken place concurrently to a boom in index investing, does not mean that one has caused t’other.

You’ll probably be unsurprised to hear that no, I don’t think that the rise of index strategies is going to fundamentally “break” the stock market. I think this a self-serving yarn spun by an industry determined to protect margin at all costs.

In support of my position, I present the court with two primary arguments.

1. Index funds haven’t been adopted by everyone.

Although passives, as a proportion of the UK market, have doubled in the past ten years - they still only represent 25% of the UK investment market as defined by the Investment Association.

It is a bit higher in the US to be fair, where index funds are now in the majority.

But only just, and there is a ways to go until they completely dominate. I don’t think they ever will by the way, the allure (and marketing budgets) of active management/stock picking/hedge fund super brains just being too high.

2. Passive strategies are price takers not makers.

   
   

And anyway, even if active managers end up in the minority this doesn’t really matter as they are the ones that set the prices in the market.

This one can be a little difficult to get my head around occasionally, so I’ll do my best to explain this simply.

All index funds have a mandate to do, is to replicate the stock weightings within a given index. They are totally price agnostic, they don’t care what price a given stock trades at - they just buy or sell it to adjust their position accordingly.

Passives are therefore just “price takers” - prices are set by the active managers, usually the hedge funds, each day. In other words if a stock is overvalued, it isn’t the fault of passive strategies. Traders have collectively set the price there for passives to follow.

This is all theoretical at the moment of course, but I don’t think a functioning market needs the majority of participants to be willing price makers. I may be wrong, please do correct me below the line if you think I am.

Even if you don’t buy any of my arguments and still want to steer clear of index investing - you still have to buy something. Assuming you’re not going to stick it under the mattress.

Active managers will claim their skill can protect an investor during times of stock market difficulty. One for another day, but I’m pretty sure the data says otherwise.

Anyway, investing is a long term endeavour. And over the long term the active industry collectively struggles to beat their comparator indices. Them’s the numbers.

Sure, you could pick one of the handful of funds that do but I don’t like your odds. Even if you do, you need to know when to flog them before performance turns too because, per the SPIVA numbers I have linked to above, any outperformance doesn’t seem to last.

Into the bargain, you have to be wary of picking an “active” fund which is a so called “closet tracker”. Building portfolios and making changes to largely replicate their primary benchmark anyway, while charging a multiple of what the equivalent index fund does. I have seen this live and in technicolour from the coalface.

Of all the things to worry about, passive investing getting too big is just so far down the list I can’t even.

The people pushing this agenda are doing it for one of two reasons - they are either bored to an institutional degree and/or they are flogging something.

Past performance is not indicative of future returns. None of the above is intended to constitute advice to any individual. If you have queries regarding your specific position, please do consult a regulated financial adviser.