Passive investment, celebrated for its simplicity and loved by users, is causing a stir in the financial landscape. Critics, particularly fund managers, attribute the rise of passive strategies to the industry’s fee war and claim it complicates traditional investing. Recent data from Morningstar reveals that passive funds surpassed active ones in net assets for the first time. A study suggests the sedating effect of indexing on the stock market, challenging the efficient markets hypothesis. As passive investment grows, it reshapes the investment process, posing risks and altering the game for investors.
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By Katie Martin
New research bolsters the view that it is undermining the efficient markets hypothesis
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.
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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 theiractive 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 inUS 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.
Read also:
- Elon Musk unleashes critique on US financial markets, decries regulatory burden and passive investing
- Active vs Passive investing: $100 trillion money managers confront the end of the bull market era
- Active or passive investing? How choosing between got so hard
© 2024 The Financial Times Ltd. All rights reserved.
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Passive investment refers to an investment strategy that aims to replicate the performance of a specific market index or benchmark, rather than actively selecting individual securities. It is celebrated for its simplicity and has gained popularity among investors due to its low fees and ease of use. Critics, particularly fund managers, have raised concerns about passive investment, attributing its rise to the industry's fee war and claiming that it complicates traditional investing.
According to recent data from Morningstar, passive funds have surpassed active funds in net assets for the first time This shift in assets reflects the growing popularity of passive investment strategies. The demand for passive funds has been encroaching on active funds for years, with the trend becoming more pronounced in recent times In December, the net assets in passive funds exceeded those in active funds, indicating a significant milestone in the investment landscape.
One study suggests that the increasing use of passive investment strategies may have a sedating effect on the stock market, challenging the efficient markets hypothesis The study examined the impact of currency shocks on companies and their reflection in stocks within the S&P 500 index, which is a primary target for passive investment The researchers found a lower difference in stocks' idiosyncratic currency sensitivity for stocks within the index compared to those outside the index This finding indicates that indexed stocks may be less responsive to external shocks, such as currency fluctuations.
The rise of passive investment has reshaped the investment process and poses risks for investors. As passive investment continues to grow, it may alter the dynamics of the market and the way investors allocate their capital Some argue that the increasing dominance of passive investment could undermine the efficient markets hypothesis, which suggests that asset prices reflect all available information The collective actions of passive investors may lead to a circular bet on more money flowing into the asset class, rather than seeking out and rewarding successful companies based on their fundamentals.
It is important to note that passive investment has its benefits and has unlocked wealth for many individuals who may not have otherwise participated in financial markets However, the growing body of evidence suggests that stocks may become insulated against surprises and less able to reflect fundamental factors due to the influx of passive investment flows This highlights the risk of faulty capital allocations and has implications for both passive and active investors.
In summary, passive investment has gained popularity due to its simplicity and low fees. However, critics argue that it complicates traditional investing and may have a sedating effect on the stock market. Recent data shows that passive funds have surpassed active funds in net assets, indicating a significant shift in the investment landscape. The rise of passive investment poses risks and challenges the efficient markets hypothesis.
