Two young fish swim through the ocean, passing an older fish, who says: “Hey boys, how’s the water?” The two younger fish swim on, until one turns to the other and asks: “What the hell is water?”
The late writer David Foster Wallace used this parable to illustrate how “the most obvious, ubiquitous, important realities are often the ones that are the hardest to see and talk about”. For some analysts, it is also the perfect way to describe the pervasive, under-appreciated effect that passive investing is having on markets.
Quantitative-orientated investors seeing their models fizzle? Equity valuations at illogical highs? Imperious stockpickers reduced to impotent dunces? Odd movements in the bowels of markets? Supposedly idiosyncratic securities moving together like they are doing a tango? The weird phenomenon of most stock market gains happening overnight rather than during the trading day?
All this and more can be laid at the feet of the swelling tide of passive investing, according to a band of sceptics informally spearheaded by Michael Green, chief strategist at Logica Capital Advisers. In some respects, what he is arguing amounts to something akin to a “theory of (almost) everything” for financial markets and Mr Green has turned it into a personal crusade this year. The arguments are compelling enough to warrant examination.
It is true that the indices that passive funds track have over time morphed from being supposedly neutral snapshots of markets into something that actually exerts power over them, thanks to the growth of passive investing.
Mr Green argues that this helps explain why active managers are actually seeing their performance worsen as passive investing grows. The more money index funds garner, the better their holdings do in exact proportion to their weighting, and the harder it is for traditional discretionary investors to keep up.
The broader growth trend also partly underpins rising valuations. The average fund manager typically holds about 4-5 per cent of assets in cash, as a buffer against investor outflows or to take advantage of opportunities that may arise. But index funds are fully invested.
In other words, three decades ago every $1 that went into equity funds meant 95 cents would actually go into stocks. Today it is closer to the full buck. Given the trillions of dollars that have gushed into cash-lean index funds, it leads to a secular increase in valuations, Mr Green argues.
Moreover, as indices weighted by size, the rise in passive investing mostly benefits stocks that are already on the rise. This makes the equity market increasingly top-heavy as the big become bigger. This short-circuits the popular strategies of many quantitative hedge funds of seeking to exploit “factors” such as the historical tendency for cheap or smaller stocks to outperform in the long run.
This also increases correlations, with the S&P 500’s members marching up or falling down more in unison than in the past. And it could help explain why so much of the stock market’s gains actually happen outside the normal trading day. Many index funds do their buying in the closing auction.
Nonetheless, the argument that passive investing has become a nefarious force wreaking the natural order of markets is still far-fetched. It is plausibly a factor in many phenomena, but disentangling it from the multitude of far greater forces at work is impossible.
Yes, stock market leadership is narrower than in the past. But it is not like the current giants are mirages conjured up by index funds. They are often wildly profitable, semi-oligopolistic companies growing at a hefty clip and operating on a global scale in a world of zero interest rates. In such an environment, it is natural that markets become more concentrated.
Passive investing has likely helped hot stocks with momentum behind them. But the constantly-evolving market ecosystem has always led to certain corners of the equity market outperforming or underperforming.
Most of all, the theory that passive investing would inevitably blow up and rip a hole in financial markets when the tide recedes seems a little fatuous today.
In the past dozen years, passive investing has been through two big stress tests — the financial crisis of 2008 and the pandemic of 2020 — and largely emerged strengthened. Even some sceptics now quietly admit the structure may be more resilient than they had previously thought.
Finance has a tendency to take all trends too far, and passive investing will undoubtedly prove no different. But we are not there quite yet, and it is doubtful we will be for years to come.