Updated: Feb 27, 2021
Over time, retail investors have stood to benefit from technological advancements, but perhaps none more so than the extraordinary ascent of passive investment funds. Whilst institutions like "Vanguard" and "BlackRock" have become household names by allowing retail investors to participate in equity markets in a cost-effective manner, the consequences of this widespread adoption of passive investment vehicles is largely misunderstood.
The sheer rate of growth of capital flows into passive vehicles relative to active managers in recent years is astonishing. The Global Financial Crisis (GFC) represented an inflection point from which capital flows streamed out of active managers and into passive vehicles, partly due to inordinate management fees and heavy losses sustained by active managers during the GFC.
Source: Morningstar Direct
The appeal of passive investing is self-evident: extremely low fees, tax advantages, transparency, convenience and generally speaking, superior performance when compared to actively managed funds. Endorsements from celebrated investors like Warren Buffett and John C. Bogle have also helped to legitimize passive investing in the public consciousness.
"A low-cost index fund is the most sensible equity investment for the great majority of investors. My mentor, Ben Graham, took this position many years ago, and everything I have seen since convinces me of its truth" - Warren Buffet
However, a fundamental challenge posed by passive funds is that the sheer dominance with which they have captured capital flows over the last decade has contributed enormously to the demise of price discovery.
One of the foremost experts on the impacts of passive investing is Michael Green of Logica Funds. Green has, on a number of occasions, made the argument that because these passive vehicles allocate capital based on current market capitalization or current float-adjusted market capitalization, they do not properly exercise price discretion.
In other words, passive funds are compelled to buy equities and remain fully invested for as long as there are corresponding inflows. Ironically, the demand for equities in an index and their prices are directly correlated. For example, when the price of a stock in an index increases, all things being equal, its weighting in that index will increase proportionally and as a consequence, more capital will be allocated to that stock by the passive fund, creating a reflexive feedback loop.
Hence, a passive fund's willingness to buy equities is not driven by valuation but rather by capital flows.
Famed short seller, Carson Block, recently explored the impact that passive funds have on market prices in his Financial Times article of 11 February 2021, titled "The 'stonk' bubble poses significant global risks". He writes:
"...when an incremental dollar is put to work with an active manager, it has an average effect on aggregate market capitalisation of $2.50. The multiplier occurs because the number of shares available is smaller than the total number of shares outstanding, and a buyer must pay a premium to induce a shareholder to sell...when a passive fund receives an additional dollar, the automatic decision to maintain balance by buying in proportion to market capitalisation results in an increase in market cap of more than $17."
Whilst evidence tying the impact of capital flows by passive funds to the general increase of market prices is compelling, one must assume that if passive flows were to reverse, then the adverse impact on market prices would be similarly amplified. Where capital is withdrawn from passive funds in times of market stress, as occurred in March 2020, the price insensitive nature of these vehicles can lead to significant market corrections at warp speed (i.e. the feedback loop turns negative...and fast).
There are also structural concerns with passive investing driven by demographics. Countries such as Australia and the United States are developed economies with ageing populations, where a disproportionate percentage of wealth and financial assets are in the possession of older generations (better known as "boomers"). As these individuals approach retirement age, they will be forced to withdraw capital from the market in order to fund their retirement, leading to downward pressure on equity prices.
We must be careful to recognize that large inflows of capital which ignore fundamentals and valuation can be damaging to capitalist economies, given the gross misallocation of resources.
How this passive investing story ends is anyone's guess, but while capital continues to pour in from around the globe, passive index funds will continue to bid up prices, irrespective of fundamentals.