By Mark Northway, Investment Manager at Sparrows Capital
Passive investing always divides opinion, but one recent claim is astonishingly wide of the mark.
Comments towards the end of last year made by Vincent Deluard from the brokerage StoneX suggested that passive investing is a prime cause behind distorted stock valuations and market bubbles. It is suggested that the flow of money into passives means that the stock market is effectively insulated from sustained bear markets.
These suggestions build on the conventional wisdom that passives are price-insensitive and buy the market in a value-agnostic manner. But when one reviews these claims more deeply, the logic backing them fades away.
Following the money
Firstly, looking at valuation or mis-valuation of the overall stock market as a whole, the key isn’t inflows into passive funds, but net overall inflows across active and passive combined. If people are saving in aggregate, and these savings are being directed towards the stock market, then the overall market capitalisation will rise.
But much of the money now allocated to passive investments is not new money; it has been moved there from active holdings. Reallocation from active to passive doesn’t represent a net inflow and so has no effect on overall market valuation.
And looking at the data, it seems that year-on-year growth in the aggregate amount of new money being invested in the stock market is reasonably consistent, underlining that redistribution is the primary driver of growth in passives.
In the US, the $7.3 trillion held in passive open-ended and exchange traded funds that invest primarily in the country’s equities might outweigh the $6.6 trillion in active funds, but passive’s overall share of the market is lower when direct investments outside funds are considered.
Outdated view
The criticism that passives mitigate the chances of a bear market in US equities is also overly simplistic.
It is naïve to suggest that holders of passive funds will simply keep buying if the world were crumbling around them. Riding out volatility has been shown historically to be the best approach to long-term investing, but that doesn’t mean that every participant will be able to stand the heat in the proverbial kitchen.
Price takers versus price makers
Passives are indeed value agnostic, but that doesn’t mean that they can drive over-valuations and under-valuations at a single stock level. It simply means that the price making function is delegated to active participants, whose ability to influence individual stock prices is magnified through that process of delegation.
And to Mr Deluard’s assertion that passive favours large-cap growth, this again feels like a very historic representation of passive investing.
Yes, the flow of funds is complicated by the fact that passive investors don’t all own the “market portfolio”, but instead often make active choices over sector, geography, and investment style; and those are often trend following choices, funneling investment into vogue strategies such as growth and momentum. But such active choice is the bread and butter of active funds, and can hardly be attacked as evidence of passive-led market distortion!
Rotations remain
While just five major tech stocks dominated the S&P 500 in 2020, with Amazon, Apple, Google’s owner Alphabet, Microsoft and Facebook making up a quarter of the index at one point, this wasn’t all because of passive investing.
The suggestion is that as these companies get bigger, market-cap weighted passive funds will keep buying them, and they’d keep getting bigger.
But in 2021, they collectively fell to 20 per cent of the S&P 500. Thanks to improving global growth expectations (albeit shaky due to the ongoing fight against coronavirus) both value and cyclical stocks are beginning to outperform.
The stocks at the bottom of market-cap weighted indices have started to rally, while tech’s lustre has begun to wane.
As noted in research by Interactive Investor, between November 2020 and July 2021, oil and banks outperformed e-commerce and social media companies.[1] A change in conditions saw active investors select previously out-of-favour stocks, and saw passive follow their lead.
It is time to stop blaming passive investing for the stock market trends of the day.
[1] https://www.ii.co.uk/analysis-commentary/tom-bailey-value-rally-suggests-passive-flows-do-not-drive-market-ii520769
