Recent data from Morningstar showed that at the close of 2023, assets in passive funds had overtaken those in their active counterparts. This was a moment of celebration for advocates of passive investing, but also came against a backdrop of active investors – most notably hedge fund manager David Einhorn – claiming that this shift had broken markets. So, is the continued growth of passive funds simply validation for a better way of investing, or terrible news for the efficient functioning of capital markets?

Before getting into the details, it is worth emphasizing that the rise of passive funds has been an overwhelmingly positive development for investors. It is, however, possible to believe this and still ask valid questions about its implications. The move from active to passive investing changes behaviour – so it matters for markets.

I don’t have perfect answers to the questions that follow, but they are worthy of thought.

What proportion of assets are in passive funds?

It depends on what and who you ask. The Morningstar analysis did show assets in passive funds surpassing those in active funds, but the numbers shift depending on the region we look at, how passive is defined and what type of investors (mandates, funds etc…) are captured. One interesting aspect to consider, which is often ignored, is the proportion of active strategies (those trying to beat an index) that are heavily constrained in the amount of risk they can take away from their benchmark. They may have strict tracking error constraints or limits on the size of overweight and underweight positions they can take. Although they have more flexibility than a passive fund, the behaviour of the fund managers will be heavily influenced by the evolving composition of an index.

How many active investors do you need?

It’s difficult to say. Passive funds by their design benefit from the work of others. Active investors in aggregate set the prices of securities and then passive funds mirror this. This relationship only works if there are sufficient active investors engaged in some form of evaluation and analysis. If the market were entirely made up of passive investors prices would be set by flow and liquidity; fundamental business attributes would be largely irrelevant in market pricing (barring corporate activity around dividends, buybacks and issuance).  In this scenario it would be fair to claim markets were broken in some way as passive fund behaviour would become entirely self-reinforcing and markets wouldn’t be useful in valuing businesses or providing some measure of the cost of capital.

Are all active investors trying to find ‘fair value’?

Absolutely not. Many critics of passive investing tend to create a binary distinction between passive investors being price insensitive and active investors assiduously building DCF models trying to value businesses. In my experience, this is simply not true. There are vast swathes of active investors that are far more interested in sentiment, momentum and price movements than attempting to work out something so arcane as what a company might actually be worth. The pervasive momentum and performance-chasing that we see in stock market returns is not a phenomenon caused by passive flows.

Are markets already priced by flows rather than fundamentals?

No. There is an argument that markets are already broken and dominated by price-incentive flows into passive funds, but this seems far-fetched. Let’s try a simple thought experiment – imagine that a major fraud was uncovered in one of the Magnificent 7 – would the price drop significantly because of concerns over future earnings or would the wall of money from passive funds overwhelm this? Almost certainly the answer is the former. The fluctuating fortunes of Meta in recent years seems a perfect example of market pricing still being driven (at least in part) by business fundamentals rather than flow. A far more egregious example of markets being driven by flows and sentiment was the Dot-com bubble, and that was fuelled by active investors.

Are passive investors value / fundamentals insensitive?

Yes and no. This seems like a simple one to answer but is a bit more complex than it first appears. If an investor is seeking to track the S&P 500 then they will buy irrespective of prevailing valuations, so in that sense they are insensitive to underlying business fundamentals and price. However, it is important to consider investors who are making active asset allocation decisions based on valuation and fundamentals but implementing them via passive funds. Many investors will appear valuation insensitive, but are simply considering these factors at an aggregate level rather than on an individual stock basis. (This relies on there being some active investors at a stock-level).

Passive funds just mirror current index weights, don’t they?

Not necessarily. The most compelling argument about the impact of increasing passive investment having a limited influence on markets is that that they simply invest at prevailing index weights – they perpetuate the current status quo rather than shift it. This argument only holds if we believe that liquidity and market cap scale equally, which they may not. If one listed company is 100 times larger than another is its relative liquidity 100 times greater?  If not, then an increasing $ amount of money being invested in the largest index constituents may have some disproportionate impact on prices.

Is the growth of passive funds good for active investors?

Yes. Imagine you are an active investor and you are told that passive investing has broken markets so that stock prices bear little relation to fundamentals. This is great news! You are almost certain to find the opportunity to invest in companies that are wildly mispriced. You can invest at ridiculous prices and sit back and enjoy the fundamental returns of the business (just perhaps not a revaluation of the multiple).

Is the growth of passive funds good for active investors?

No. The above answer is only correct if you don’t require markets to ‘reprice’ the securities you hold. Inevitably one of the main groups criticising the rise of passive funds is hedge funds, one of the reasons for this (away from the general loss of business) is that they typically have short horizons (one year performance fees) and seek to capture anomalies / trends before other market participants. They make money when other investors play catch-up. In a world where passive flows dominate and there are fewer investors like them this process may take longer to occur.

Overall, the rise of passive investing should be great for increasing the opportunity set for active investors interested in mispriced fundamentals, but is problematic if you have short horizons.

Does the rise of the Magnificent 7 show that markets are broken?

No. While the Magnificent 7 may be expensive, their ascent has not been detached from fundamentals. In aggregate these are incredibly successful and profitable businesses. The stunning rise of Nvidia feels like a textbook case of improving fundamentals combining with a compelling theme and performance-hungry investors, rather than anything led by the increasing influence of passive funds. It doesn’t feel like anything we haven’t seen before. 

Where is the impact of passive funds most likely to be felt?

Two obvious areas are non-index stocks and non-core markets. Stocks not featured in mainstream indices will almost certainly be impacted by the large increase in flow into passive products. This may well create opportunities, though this will be at the margins and will involve some lower quality businesses. There may also be some influence on non-core markets – for example, if the rise in passive investing increases relative flows into the S&P 500 this could impact the pricing and performance of smaller companies.

Is passive investing becoming riskier?

To an extent the more concentrated markets become the riskier a passive approach is. Let’s take things to an unlikely extreme – if the US became 90% of global equity markets with 50% concentration in the top 10 stocks and traded on 100x earnings, is a rigid passive approach still aligned with prudent investing? Probably not. But this is always a feature of passive investing not one that is caused by its growth. It is a known trade-off that passive investors must weigh up against the advantages. (Passive investors would have been buying a lot of Japanese equities at the peak of their bubble).

Does the rise of passive funds change investor time horizons?

Yes. It is reasonable to believe that increasing flows into passive fund requires fundamentally driven, active investors to increase their time horizons because on balance it may take longer for those fundamental factors to come to pass – at a security level there are fewer valuation sensitive buyers and greater weight of money invested at index weights. This creates something of a dichotomy because the rise of passive funds has inevitably shortened investors’ horizons – the tolerance for underperformance in active funds has likely reduced because the switch to passive is so easy.

The edge available to active investors with a long-time horizon is probably increasing, but the ability to adopt such a horizon is reducing.
 
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It is hard to disassociate valid questions about the implications of the rise in passive investing from gripes by individuals and groups who have been disadvantaged by its growth. The market has evolved, however, and it would be remiss not to consider what that may and may not mean.  On balance much of the market activity that is used as evidence of the pernicious impact of passive investing feels like behaviour we have experienced in the past, long before passives played such an influential role. That is not to say there has been no impact, nor that it is a phenomenon to disregard, but, as it stands, my best guess is that the rise of passive may make trends run a little harder and reversals more severe, but it is difficult to argue that markets are broken.

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Links

Morningstar: Passive Overtakes Active

Masters in Business – David Einhorn Interview
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My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

Thinking and talking about failure can be tough, especially if it’s us who’s got something wrong.

But it’s vitally important for us as individuals and teams to find a way to address failure that allows us to both learn and evolve. In this episode of Decisions Nerds we:

– Examine my framework for thinking about errors around investment beliefs, processes and outcomes.

– Think about this in the context of broader typologies of errors; basic, complex and intelligent.

– Discuss some of the key psychological factors around failure and how they can be managed.

Some key takeaways:

The world of investing is filled with uncertainty and many of our decisions are going to be wrong.

We tend to look away from errors because of confusion about what caused them and fear of repercussions.

We can make life easier for ourselves when:

1.⁠ ⁠We accept failure and build processes that make us examine it.

2.⁠ ⁠We develop clear typologies of failure that are rooted in the decisions our teams make.

3.⁠ ⁠We build cultures of strong psychological safety.

As a bonus, you can hear me enjoy some live tech failures to bring the episode to life.

Play below, or find in all your favourite pod places.

https://decisionnerds.buzzsprout.com/2164153/14540844

It will not have escaped anyone’s attention that 2024 is a significant political year. Over 50 countries – home to somewhere near half of the world’s population – will hold elections. This – in particular the US presidential vote – is currently exercising financial markets. There is much talk of rising uncertainty* and a frenzy of predictions about results and their consequences. Given this backdrop, investors have every right to be worried, but perhaps not for the expected reasons. We should be focusing less on the specifics of the elections and more on avoiding the poor decisions we are likely to make because of them.

A US election is fertile ground for market forecasters. They can speculate both about the result of a significant occurrence and the market’s response to it. The prognostications typically involve either predicting the short-term reaction of market participants (how other people doing the same thing as them will act), or specifying some longer-term structural shifts that might occur as a consequence (what happens to the US dollar? Which industries stand to benefit?)

Should we act based on either of these types of predictions? Our strong default should be no. These are highly unpredictable, impossibly complex and chaotic subjects that we are understandably not very good at judging. Will some market soothsayers be right? Probably. Do we have any idea who will have that honour this time around? Probably not.

It is not just that it is incredibly difficult to make forecasts or to know whose forecasts to follow, but for most investors the thing we are anxious about will matter much less in meeting our specific goals than we think.

The challenge is that the industry compels action – it generates far more heat than light. It wants us to trade, to switch funds and to pay for critical insights. Even investors who really don’t want to engage with these issues are forced to simply because everyone else is – otherwise we risk seeming negligent.

There are two critical questions to consider when ‘significant’ market events are looming, or we are tempted to trade because of some noteworthy development:

1) Is it important to achieving our goals? Generally, events are far less critical to investors and our long-run returns than we perceive them to be.

2) Can we predict the event and the market’s reaction to it? Almost always the answer to this question is no.

It remains fascinating how investors face an incessant bombardment of evidence about how bad we are at making predictions and timing markets, yet we continue to persist with a punishing indefatigability. We were wrong yesterday but will be right today.

Major events – such as elections – are particularly pernicious because their prominence means that the urge to act can prove irresistible. As humans we are wired to deal with what is right in front us. The more salient and available an issue, the more we are likely to act. Far better to do something destructive than to be a bystander.

As difficult as it is, as investors we would be well-placed to reframe our approach. Rather than respond to each major event or period of ‘increased uncertainty’, we should instead try to move our focus to managing behavioural risk. That is identifying environments where we are likely to make poor investment decisions that damage our long-term returns, such scenarios might be:

– Significant market / macro events (elections / recessions / wars)

– Periods of extreme performance (bubbles and busts)

– Paradigm shifts (the next new transformative market narrative)

In these environments – where the behavioural risk gauge is flashing red – it will be the poor decisions we make because events are happening, rather than the events themselves, that will be of greater consequence.

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* I am always slightly sceptical of the warnings of rising market uncertainty. Both because markets are always uncertain but more because it suggests that we were more certain about markets before they became uncertain (which means we were wrong to be more certain in the first place!)

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My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

It is so tempting to get lost in the noise and intrigue of financial markets that we can easily forget what type of investor we are. Although the investing community can at times appear something of an amorphous blob attached to the latest in-vogue topic; groups of participants are engaged in wildly different activities that – at anything but a cursory level – are barely related. To have any chance of success it is critical to understand the realities of our own approach and avoid playing somebody else’s game.

In broad terms, I think there are four investor types:

Trader

A trader operates with ultra-short time horizons (intra-day to weeks) and is typically engaged in the prediction of price movements based on historic patterns or the expected market reactions to certain events (if X happens, prices will do Y). Asset class valuations and fundamentals are largely irrelevant, and the focus is on forecasting the response function of other investors.

This is staggeringly difficult to do consistently well, which is why profits often seem to accrue to the people who teach trading to others rather than do it themselves.

Price-Based Investor

Almost certainly the most common active investment approach. Price-based investors have short time horizons (ranging from three months to perhaps three years) and tend to engage in one of two related activities:

1) Predicting future market / macro factors and how other investors will respond to them. “We believe that the Fed will be more accommodative than the market expects, which will support US equities.”

or

2) Predicting how other investors will react to realised market / macro factors. “The Fed is far more dovish than the market expected, therefore we have increased our exposure to US equities.”

The common factor in both of these closely related methods is that investors are guessing how other investors will behave. This is similar to trading, but the horizons are extended (though still what I would class as short-term). In essence it is an attempt to capture anticipated price trends.

Valuations and fundamentals matter somewhat for this group, but only insofar as they are useful for understanding the positioning and future decisions of other people like them.  

This is probably the most comfortable style of investing from a behavioural perspective as it caters to plenty of our biases – our desire to be active, to be part of the herd, to tell stories. For similar reasons, it is also likely to prove the most prudent survival strategy for professional investors.  

The problem is that it is incredibly challenging to get these types of calls right (or even more right than not).

Valuation-Based Investor

This type of investor is focused on the fundamental attributes of an asset and will look to make some assessment of expected return or fair value based on analysis of starting price and future cash flows. Given that price fluctuations dominate short-term asset class performance, a long view is essential.

It is important not to confuse a valuation-based approach with value investing, which is only a subset of it. Valuation-based investors are seeking to identify asset mispricings – these might occur because the level of growth is underappreciated, or high returns on capital will persist. The key distinction is that the focus is on the returns produced by the asset rather than how other investors might trade it.

Given that market movements over short and medium horizons often bear little relationship with the fundamental features of an asset class, a valuation-led approach is undoubtedly the most behaviourally taxing. This group will inevitably spend a great deal of time appearing out of touch and idiotic, even if they are right, and they might end up waiting years for validation that never arrives (taking a valuation-led approach doesn’t mean that you will necessarily be correct in the end).

Relative to a price-based investor they are more likely to be successful in their investment decision making, but also more likely to lose their job.  

Passive Investor

Although there is no purely passive portfolio, this group seeks to invest in a fashion that can be considered a broadly neutral representation of the relevant asset class opportunity set (by size). While passive investors are inherently agnostic on valuation, they do care about the fundamental features of the assets in which they invest, but specifically in regard to the ultra-long run, or structural, expected risk and return.

A passive investor may not believe that markets are efficiently priced, but simply there is no reasonable and consistent way of capturing any inefficiencies (certainly relative to the effort or behavioural stress required), particularly after costs.

Although a long-term, passive approach appears simple it is not without behavioural challenges – doing nothing is tough and rarely lucrative.  There will also be incessant speculation around how some profound change in asset class behaviour will soon render a passive approach defunct. 

But perhaps a more credible problem is that a purely passive style requires investors to be ambivalent about extreme asset class overvaluation – passive investors are fully / increasingly exposed to equities trading at 100x PE or bonds yielding zero – even if the evidence suggests this will lead to derisory future returns. It is reasonable to suggest that this is a known cost and one which still leaves it superior to other strategies. It should not, however, be ignored.

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These categories are not quite as discrete as I have made out, but the overall point holds. Defining our own approach and understanding its realities and limitations is absolutely critical for any investor. This requires setting realistic expectations, knowing the information that matters and what should be ignored, and preparing for the specific behavioural issues we will encounter. Failure to do this will mean we will inevitably become part of that amorphous blob.

All investors should be asking who they are and what it means.

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My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).