Passive can be problematic

the disguised precariousness of passive investing

Mar 16, 2023

On February 5^th, 2018, XIV, a $2 billion entity collapsed within itself, reducing its assets to $63 million. A mere ten stocks are contributing 116% to the S&P 500 Total Return Index, while the remaining are contributing -16% by the end of 2018 (Catalyst 2022). Passive funds own a whopping 53.8% of the U.S. domestic equity funds in early 2021. How did we get here?

In this article, I try to explain how passive investing has enormously expanded in the recent past and its problems, including how it is causing valuations to get inflated, how cashflows into the market are getting reduced, the effects of proxy voting, and how the funds are getting concentrated in a handful of companies.

Passive investing is when you just buy and hold. A more textbook definition would be:

“Passive investing is an investment strategy to maximize returns by minimizing buying and selling. Index investing is one common passive investing strategy whereby investors purchase a representative benchmark, such as the S&P 500 index, and hold it over a long-time horizon.”

These indexes are run by asset-management firms. They have special products called exchange-traded funds (ETFs), which have multiple categories ranging from the ones tracking the performance of a sector to a country to the whole world.

How did we get here?

In recent times, many people lost faith in active investing and started moving towards passive approaches. For anyone who doesn't want to do the tedious task of researching and picking individual businesses which still can lead to irrecoverable losses, getting into passive is one of the most reasonable choices. It is reasonable because matching the performance of an index is still better than underperforming it. Getting into passive also saves you the heavy costs which eat up the returns generated by the active investors. It is also tax efficient and has beaten most active investors over the long run. All passive players have to do is give their money to an index and sit back until they retire or until they face a big need for cash. Active managers try to beat the benchmark whereas all passive managers do is just match the performance of the benchmark. Passive people are going to buy even if the markets are heavily overvalued, whereas active ones are more meticulous in when and what they buy. These flows from the passive push the markets up even more. As Kyla puts it it’s like two persons going to a supermarket.

The active one is going to use discounts and coupons and time their purchase to get the best deal.
The passive one is going to buy even when the prices are extremely exorbitant.

And if we have a big chunk of people buying things at 2x the price, normalization of the market would take place.

Demographics behind the shift

There is also a demographic reason behind this. Boomers are going to retire and pull out their cash from the actively managed funds. On the other hand, Gen Z is aging and most of their retirement funds are set up passively. This creates a perfect concoction for skewing towards passive. This displacement into passive results in the market behaving like a single stock – all stocks are correlated and are moving together. This will also lead to higher volatility and inflated valuations. Since an average passive investor wouldn’t care about the market fundamentals or news or reports, they keep investing and hence increasingly pushing valuations to the upside. The market looks more and more like a utopia even if it is not. As passive investors keep doing this, active managers keep trading amongst themselves in a less liquid environment. The price-setting ability of active investors gets reduced and there will be no real “diversification” in index funds, as everything moves a single entity.

The market structure is getting transformed. In the 1970s, Fidelity had about 2% of the market. Now BlackRock, Vanguard, StateStreet, and Fidelity each own about 7-9% of the market, meaning they roughly own 50% of the market. In S&P 500 Total Return Index 10 stocks are contributing 116% to its returns and the remaining stocks in the index are contributing -16% by mid-2018. This is because the index is built up proportionate to the market capitalization of the companies. As significant funds flow into these index funds, the largest stocks, mostly tech, will get the most allocation and this creates a self-reinforcing loop. In case of an exogenous event, these large stocks are under significant risk as investors will offload their exposure rapidly.

Accomplished investors like Peter Lynch, Carl Icahn, and, Michael Burry have also called out on passive investing. Peter has said, “This move to passive is a mistake" in a Bloomberg Interview. Michaela Burry has also made similar claims and has said that passive is a “bubble”.

Proxy voting problem

There are problems with proxy voting as well. In a normal scenario common shareholders vote on some of the company issues, board of directors, executive compensation, and other corporate matters. However, if you are investing through vehicles like mutual funds or exchange-traded funds, the asset-management firm will be taking voting on behalf of you, by proxy. This will result in asset-managing companies amassing great power and will have significant say in how companies will function.

John Coates has argued that

“in the near future roughly twelve individuals will have practical power over the majority of U.S. public companies”

After looking at the backlash that asset-managing firms were facing, they started trying to expand the opportunities for clients and make their voices heard. Recently BlackRock has started giving large institutes like endowment funds and pensions an option to vote themselves. Yasmin Bilger, managing director and head of ETFs at Engine No. 1 has told that

“For years, the typical S&P 500 fund voted against 80% or 90% of social and environmental shareholder proposals. For many investors, that’s not good enough”

These firms clearly need to take action to make the voices of individual investors heard using new techniques and technologies.

Passive investing is changing the inherent structure of the market and is probably here to stay. It certainly is one of the most reasonable choices to make and it did increase the accessibility to the markets, but it is important to understand its repercussions on the functioning of the markets and it is even more important to hedge the downside of your passive investments. Unlike active investors who hedge, their positions, meaning they set up a kind of insurance using several techniques to exit their positions when they get too risky. The monopoly that asset management firms enjoy is starting to collapse, and hopefully there will be more measures to make the retail investors voices heard.

Thanks for reading.

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