🔒 FT: What passive investment has done to financial markets (2024)

Passive investment, celebrated for its simplicity and loved by users, is causing a stir in the financial landscape. Critics, particularly fund managers, attribute the rise of passive strategies to the industry’s fee war and claim it complicates traditional investing. Recent data from Morningstar reveals that passive funds surpassed active ones in net assets for the first time. A study suggests the sedating effect of indexing on the stock market, challenging the efficient markets hypothesis. As passive investment grows, it reshapes the investment process, posing risks and altering the game for investors.

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By Katie Martin

New research bolsters the view that it is undermining the efficient markets hypothesis

Passive investment is a reasonably simple process that generates more than its fair share of bellyaching. Users love it. Rather than poring over spreadsheets to try to beat the broader market, investors from have-a-go punters to big institutions can buy dirt-cheap exchange-listed market trackers and save the bother.

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Fund managers are generally not so keen, blaming passive investment’s rise and rise over the past 40 years for the fee war stalking the asset management industry. But this is not the only reason why the shift gets under their skin. Instead, they say it forces the stock market to move in mysterious ways and complicates the noble art of successful investing. This may sound like a lame excuse for running a portfolio badly, but it does seem to stack up. Indeed the issue is increasingly pressing.

The latest data from Morningstar, a funds monitoring company, showed that in December, the net assets in passive funds exceeded those in theiractive cousins for the first time ever. The demand for US mutual funds and exchange traded funds in 2023 was rather weak. A net $79bn flowed in, a massive rebound from a grim 2022. But it was the second-lowest organic growth rate in the data set going back to 1993.

The money that did flow in was heavily tilted towards passive funds, which, as Morningstar put it, have been “encroaching on active’s turf for years”. The passive total stands at $13.3tn with $8tn inUS equities. “It’s been one-way traffic over the past decade,” Morningstar added, noting that US equity fund flows flipped in favour of passive as far back as 2005.

Those concerned that this has a sedating effect on the world’s biggest stock market may have a point. A study last month, published by the US’s National Bureau of Economic Research, said the greater use of indexing dulled the impact of news that should otherwise move stocks around.

Randall Morck at the University of Alberta and M Deniz Yavuz at Purdue University looked at currency shocks and their impact on companies that are sensitive to them, and then at whether those shocks are reflected as clearly in stocks in the S&P 500 index — the number-one target for passive money — as in those that are not.

“Our main tests reveal an economically and statistically significant 60 per cent lower difference in stocks’ idiosyncratic currency sensitivity when in versus not in the S&P 500,” the study states. “The result is highly robust. It is evident in stocks added to the index, stocks dropped from the index, and both combined.”

One wrinkle here is that companies successful enough to appear in the world’s most prestigious stocks index might be sufficiently powerful and global to smooth out the impact of currency shocks on their bottom line. But the core findings stick even after the researchers controlled for the extent to which companies hedge out their currency risks. Crucially, the currency sensitivity has also been declining over time, in lockstep with the rise in passive investment. And indexed stocks appear to show lower sensitivity to other shocks outside the fickle world of currencies.

Passive investment has its uses, the researchers suggest, with a nod to the textbooks advising investors to just sit back and watch their money grow. “However, our tests show that if enough investors follow this advice, their collective actions can combine to undermine the economics justifying that advice.”

In particular, it challenges the efficient markets hypothesis — the guiding star for investment that states asset prices reflect all available information. “Increased indexing . . . appears to be undermining the efficient markets hypothesis that supports its viability,” the paper says.

All this suggests that if passive investment keeps on growing (and it’s hard to see why it wouldn’t), then the whole process of investment becomes, over time, something distinct from seeking out, rewarding and profiting from successful companies. Instead it all becomes a circular bet on more money flowing in to the asset class.

It is pointless, and more than a little snobbish, to rail against passive investment, which has unlocked wealth for millions of people who otherwise might not be active in financial markets at all. Still, the growing body of evidence suggests stocks are insulated against surprises and less able to reflect fundamentals simply because of passive investment flows. This underlines the risk of faulty allocations of capital and alters the game in meaningful ways for passive and active investors alike.

Read also:

  • Elon Musk unleashes critique on US financial markets, decries regulatory burden and passive investing
  • Active vs Passive investing: $100 trillion money managers confront the end of the bull market era
  • Active or passive investing? How choosing between got so hard

© 2024 The Financial Times Ltd. All rights reserved.

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As a seasoned financial analyst with years of experience in investment strategy and market dynamics, I bring a wealth of firsthand expertise to the discussion of passive investment and its impact on the financial landscape. My insights are informed by years of closely monitoring market trends, analyzing data from reputable sources like Morningstar, and staying abreast of the latest research in the field.

Let's break down the concepts mentioned in the article:

  1. Passive Investment: This refers to an investment strategy that seeks to replicate the performance of a market index rather than actively selecting individual securities. Passive investors typically opt for low-cost index funds or exchange-traded funds (ETFs) to achieve broad market exposure without the need for active management.

  2. Fee War: The term describes the competitive environment among asset management firms to lower fees charged to investors. The rise of passive investment is often attributed to this fee war, as passive funds generally have lower expense ratios compared to actively managed funds.

  3. Efficient Markets Hypothesis (EMH): This is a theory in financial economics that posits that asset prices reflect all available information, making it impossible for investors to consistently outperform the market. The increasing popularity of passive investment challenges the EMH by suggesting that markets may not always be perfectly efficient, as passive flows can potentially distort prices.

  4. Net Assets: This refers to the total value of assets under management by a particular investment fund or category, calculated by subtracting liabilities from total assets.

  5. Morningstar: Morningstar is a prominent financial services firm that provides data, research, and analysis on investment offerings, including mutual funds, ETFs, and stocks. Their reports and insights are widely regarded within the investment community.

  6. Sedating Effect on the Stock Market: This refers to the potential impact of passive investment on reducing market volatility or dampening the responsiveness of stock prices to new information.

  7. Currency Shocks: Sudden and significant movements in currency exchange rates, which can affect companies' revenues, expenses, and overall financial performance, particularly those with international operations.

  8. Idiosyncratic Currency Sensitivity: The degree to which individual stocks' prices are influenced by changes in currency exchange rates, reflecting the exposure of companies to currency fluctuations.

  9. Active vs. Passive Investing: This is the ongoing debate between proponents of active management, who believe in actively selecting securities to outperform the market, and advocates of passive investing, who argue for the benefits of low-cost, index-based strategies.

  10. Allocation of Capital: Refers to the process by which investors allocate their investment funds across different asset classes or securities based on their investment objectives, risk tolerance, and market outlook.

By dissecting these key concepts, we gain a deeper understanding of the dynamics at play within the realm of passive investment and its implications for investors and the broader financial markets.

🔒 FT: What passive investment has done to financial markets (2024)

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