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Passive investing is a fairly simple process, but it generates more than its fair share of frustration. Users love it. Rather than poring over spreadsheets to beat the broader market, investors ranging from large institutional investors can save themselves the hassle by purchasing a very inexpensive exchange-listed market tracker.
Fund managers are generally less enthusiastic, blaming the wealth management industry’s fee wars for the rise of passive investing over the past 40 years. But this is not the only reason why change is becoming more profound. Instead, they say, it forces the stock market to move in mysterious directions, complicating the noble art of successful investing. This may sound like an excuse for a poorly managed portfolio, but it seems to add up. Indeed, the problem is becoming increasingly pressing.
The net assets of passive funds exceeded those of active funds for the first time in history in December, according to the latest data from fund watchdog Morningstar. Demand for U.S. mutual funds and exchange-traded funds was fairly weak in 2023. Net inflows of $79 billion marked a major rebound from a difficult 2022. However, this was the second lowest internal growth rate in the data set dating back to 1993.
The money that’s actually flown in has been heavily tilted toward passive funds, which Morningstar says have been “encroaching on the turf of actives for years.” The total passive market is $13.3 trillion, of which $8 trillion is in US stocks. “The past decade has been a one-way street,” Morningstar added, noting that U.S. equity capital flows have gone passive as far back as 2005.
Those who fear this will have a calming effect on the world’s largest stock market may have a point. A study released last month by the U.S. National Bureau of Economic Research found that the increased use of indexes has weakened the influence of news that should move stock prices.
Randall Mauk of the University of Alberta and Deniz Yavuz of Purdue University examine currency shocks and their impact on sensitive companies, and whether those shocks are clearly reflected in S&P 500 stock prices. I investigated whether. One of the targets of passive money is similar to what it is not.
“Our primary tests reveal that the difference in idiosyncratic currency sensitivity of stocks is economically and statistically significantly 60 percentage points lower when they are included in the S&P 500 and when they are not. ” says the study. “The results are very robust, as you can see by looking at stocks that added to the index, stocks that dropped from the index, and stocks that combined both.”
One drawback here is that companies that are successful enough to be listed on the world’s most prestigious stock indexes have enough power and global scale to smooth out the impact of currency shocks on their earnings. This means that it may have the following. But even after the researchers controlled for the extent to which companies hedged their currency risk, the core findings remained the same. Importantly, currency sensitivity has also declined over time, in line with the rise in passive investing. And index-tracking stocks appear to be less sensitive to other shocks outside of the fickle world of currencies.
In a nod to textbooks that advise investors to just sit back and watch their money grow, researchers suggest that passive investing has its uses. “However, our tests show that if enough investors follow this advice, their collective behavior can combine to undermine the economics that justify it. It has been.”
In particular, it questions the efficient markets hypothesis, the guiding star of investing that holds that asset prices reflect all available information. “The increase in indexing… appears to be undermining the efficient market hypothesis that underpins its viability,” the paper states.
All of this suggests that if passive investing continues to grow (although it’s hard to understand why it doesn’t), over time the whole process of investing will change, seeking out and rewarding successful companies and focusing on them. It is different from profiting from. Instead, everything becomes a cyclical bet on more money flowing into that asset class.
It is pointless to criticize passive investing, and it is rather an over-the-top look. Passive investing has unlocked wealth for millions of people who might not otherwise participate in financial markets at all. Still, there is a growing body of evidence that passive investment flows alone protect stocks from surprises and are less reflective of fundamentals. This highlights the risk of capital misallocation and changes the game in meaningful ways for both passive and active investors.
katie.martin@ft.com
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