In 2024 it seems highly likely that passive investing will overtake active fund management and predominate in the market.
Academic studies on the subject are backward looking, focusing mainly on measuring the passive funds. Very little has been written about where this jockeying for dominance will lead to, but it is increasingly clear that passive will soon be the bigger part of the market.
The future is coming at us fast. The rise of the passives has been aided by the continued sad performance of the actives.
Imagine it like a sine curve, or the rate of change of darkness as we go from summer to winter. The trend towards passives is coming up to the autumn equinox; as it picks up more speed, the underperformance of actives becomes self-fulfilling. What active manager keeps as much as 14 per cent of their portfolio in just Apple and Microsoft?
US passive funds may do this, and such is the buying power of those funds, that when entering the market to buy more, they may have the capacity to support those share prices.
I discussed this conundrum recently with one of Britain’s finest mathematicians to see if we could get a jump on the quant funds with some complicated new forward predicting algorithms.
He considered the problem afresh and said: “The S&P 500 is an algorithm.” And right there, the efficient market hypothesis flies out of the window. If the passives are using an algorithm, we can improve on it.
Let’s go to the end of the game and work backwards to find an inflection point. Imagine the trend plays out and all funds become passive. All actives have given up, crushed and destroyed by poor relative performance. I know it will not ultimately come to this, but what if?
A note by Sanford Bernstein in 2016 says passive investing allocates capital worse than Marxism, as no one is even trying to decide what is an efficient place to invest. It would seem that we’ve gone from Adam Smith’s 'invisible hand', past the controlling hand of Marxism, to no hand at all.
Imagine that we end up with all funds being passive. They can only invest by taking account of market cap. No news matters, and so volatility is diminished. This encourages companies to reduce debt levels and sell new equity. The passives’ only concern is the weight of a company’s stock in the index. And so, the big get bigger.
If through some past cultish behaviour a stock has achieved bigness without immediate merit (that’s two steps forward Amazon and Tesla and one step forward Nvidia), that valuation can hold indefinitely.
In this passive world, if the stock then has bad earnings, it won’t go down. Volatility goes ever lower, only being affected by macro externalities that change fund flows. For example, interest rates become more important as bonds compete with stocks for these flows.
