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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