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Opinion Investments

Grumblers about passive investing may have a point

New research bolsters the view that it is undermining the efficient
markets hypothesis
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Katie Martin
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Over the shoulder view of a woman looking at financial data on a
smartphonePassive investing has unlocked wealth for millions, but
research suggests that if too many investors follow suit, their
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Katie Martin

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Passive investment is a reasonably simple process that generates more
than its fair share of bellyaching. Users love it. Rather than poring
over spreadsheets to try to beat the broader market, investors from
have-a-go punters to big institutions can buy dirt-cheap
exchange-listed market trackers and save the bother.

Fund managers are generally not so keen, blaming passive investment's
rise and rise over the past 40 years for the fee war stalking the
asset management industry. But this is not the only reason why the
shift gets under their skin. Instead, they say it forces the stock
market to move in mysterious ways and complicates the noble art of
successful investing. This may sound like a lame excuse for running a
portfolio badly, but it does seem to stack up. Indeed the issue is
increasingly pressing.

The latest data from Morningstar, a funds monitoring company, showed
that in December, the net assets in passive funds exceeded those in
their active cousins for the first time ever. The demand for US
mutual funds and exchange traded funds in 2023 was rather weak. A net
$79bn flowed in, a massive rebound from a grim 2022. But it was the
second-lowest organic growth rate in the data set going back to
1993. 

The money that did flow in was heavily tilted towards passive funds,
which, as Morningstar put it, have been "encroaching on active's turf
for years". The passive total stands at $13.3tn with $8tn in US
equities. "It's been one-way traffic over the past decade,"
Morningstar added, noting that US equity fund flows flipped in favour
of passive as far back as 2005.

Those concerned that this has a sedating effect on the world's
biggest stock market may have a point. A study last month, published
by the US's National Bureau of Economic Research, said the greater
use of indexing dulled the impact of news that should otherwise move
stocks around.

Randall Morck at the University of Alberta and M Deniz Yavuz at
Purdue University looked at currency shocks and their impact on
companies that are sensitive to them, and then at whether those
shocks are reflected as clearly in stocks in the S&P 500 index -- the
number-one target for passive money -- as in those that are not.

"Our main tests reveal an economically and statistically significant
60 per cent lower difference in stocks' idiosyncratic currency
sensitivity when in versus not in the S&P 500," the study states.
"The result is highly robust. It is evident in stocks added to the
index, stocks dropped from the index, and both combined." 

One wrinkle here is that companies successful enough to appear in the
world's most prestigious stocks index might be sufficiently powerful
and global to smooth out the impact of currency shocks on their
bottom line. But the core findings stick even after the researchers
controlled for the extent to which companies hedge out their currency
risks. Crucially, the currency sensitivity has also been declining
over time, in lockstep with the rise in passive investment. And
indexed stocks appear to show lower sensitivity to other shocks
outside the fickle world of currencies.

Passive investment has its uses, the researchers suggest, with a nod
to the textbooks advising investors to just sit back and watch their
money grow. "However, our tests show that if enough investors follow
this advice, their collective actions can combine to undermine the
economics justifying that advice."

In particular, it challenges the efficient markets hypothesis -- the
guiding star for investment that states asset prices reflect all
available information. "Increased indexing . . . appears to be
undermining the efficient markets hypothesis that supports its
viability," the paper says.

All this suggests that if passive investment keeps on growing (and
it's hard to see why it wouldn't), then the whole process of
investment becomes, over time, something distinct from seeking out,
rewarding and profiting from successful companies. Instead it all
becomes a circular bet on more money flowing in to the asset class.

It is pointless, and more than a little snobbish, to rail against
passive investment, which has unlocked wealth for millions of people
who otherwise might not be active in financial markets at all. Still,
the growing body of evidence suggests stocks are insulated against
surprises and less able to reflect fundamentals simply because of
passive investment flows. This underlines the risk of faulty
allocations of capital and alters the game in meaningful ways for
passive and active investors alike.

katie.martin@ft.com

Copyright The Financial Times Limited 2024. All rights reserved.
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