Does passive investing undermine capitalism?

Passively managed products account for one third of U.S. mutual fund assets today—up from 20% four years ago—reflecting a net US$2 trillion shift to passive and away from active management.
But questions about this trend’s sustainability, and warnings about its consequences, have arisen. Take, for instance, the note from brokerage firm Sanford C. Bernstein, entitled “The silent road to serfdom: why passive investing is worse than Marxism.” In it, analyst Inigo Fraser-Jenkins argues that active management helps the efficient allocation of capital, an important function in a free market.
For our part, we define passive investing as cap- or market-weighted indexing derived from the total market value of component holdings. All others, including alternative or smart beta, are forms of active management that require periodic rebalancing.
What consequences does the continuing movement toward passive investing suggest, and what does it mean for investors and advisors?

Valuation concerns

Passive investing does not involve analyzing individual companies, so relative and absolute valuations may be distorted, impairing the market’s ability to effectively allocate capital based on enterprise merit.
The less money available for selecting companies with better prospects, the worse off the function of price discovery that underpins the capital markets—and capitalism itself. This is the concern of Bernstein’s note, which references economist Frederich Hayek’s “The Road to Serfdom” and the complaint against “free-riding” indexers.
But consider that the annual turnover rate of active mutual fund holdings in the U.S. is 85%, according to The Motley Fool. That compares to 4.98% for the S&P 500 and 4% for the S&P/TSX Composite. So, even if passive grows to 80% of assets, the turnover from the 20% active slice would be $3 trillion—certainly enough for price discovery. More compelling than that argument is Ayn Rand’s idea of self-interest, a force that would ensure that asset mispricing wouldn’t last for long.

Diversification concerns

The investment industry’s primary risk management tool is diversification. If money flows into (or out of) all the holdings of an index at the same time, all components will move in the same direction, blunting the effectiveness of diversification against volatility.
I’d argue that risk management is most needed to protect against major declines. But when those major declines are happening, correlations tend towards 1.0, rendering diversification less effective. Advisors need better risk management tools generally, and those tools could compensate for the anti-diversification effects of passive investing en masse.

Performance

Most active managers underperform their passive benchmarks through most periods—as shown by the S&P Dow Jones SPIVA scorecard—contributing to the popularity of passive investing. But no trend goes on forever. Consider personal leverage in 1929, corporate leverage in 1987, oil stocks in the 1980s and technology stocks 2000-2001. Surely active management will have its day?
The reality is that active performance before costs equals passive performance, and this would be the case regardless of the proportion of active and passive management employed.
Passive investors would not trade and active investors would trade only with each other. Active managers in aggregate represent a cap-weighted market index.

Distortions

Passive investing can create distortions in three circumstances. First, net cash flows into a passive portfolio create a cash position, leading to a performance difference from the index until the cash is invested. Second, when passive funds are forced to buy or sell, the lack of liquidity of some smaller index components may temporarily push prices higher or lower than would otherwise be the case.


Third, when the index’s composition changes, there is a period of adjustment as passive portfolios sell the removed companies and buy replacements. The cost of these changes was estimated to be 0.2% per annum in the U.S., according to Winton Capital.
After eight additions were made to the S&P TSX Composite on September 16, 2016, they were up an average of 4.2% in their first week while the index advanced only 0.4%. So, pricing distortions can follow changes to an index.
Investors need to be aware of the distortions caused by passive strategies. They allocate capital by market capitalization but can also impact individual holdings.

In a passive world, winners are investors

Motivated market players will always find market mispricing and arbitrage it away. Valuation distortions should lead to more opportunities for active managers, but the difference between the most over- and undervalued assets is an important factor in determining this. Since less-skilled investors may move to passive investing, leaving more skilled active managers to undertake price discovery, these spreads may narrow. Better long/short strategies will also close this gap.
Corporate governance may also improve as large, passive shareholders like Vanguard use their influence across all their holdings, including the smallest ones that may have escaped previous institutional scrutiny. Investors are the winners. The biggest future losers from more passive encroachment will continue to be active managers, unless they find a way to beat their passive benchmarks with more consistency or develop a value proposition using passive issue selection within active allocation strategies.

Mark Yamada is President of PÜR Investing Inc., a registered portfolio manager and software development firm. Disclosure: PÜR Investing Inc. sub-advises for, and provides risk-based model portfolios to, Horizons ETFs.