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The Era of Passive Investing Begins

The US stock market just crossed a major threshold.


For the first time in history the assets in passive mutual funds and exchange-traded funds (‘ETFs’) investing in US stocks overtook “active” stock picking mutual funds.


According to mutual fund research firm, Morningstar, the respective balances in August were US$4.27 trillion and US$4.25 trillion.


The passive versus active investing war is over. Passive won.


This is a huge victory for the small investor. The growth in passive funds has simplified investing, driven costs down improving returns net of fees, and allowed the average mom and pop investor to keep more of their hard-earned cash.


Non-monetary advantages include the ability to chuckle at the Wall Street emperors as they parade in their fabulously-spun invisible finery.


As Harvard law professor John Coates put it, this trend “reflects the slow but steady victory of a simple set of financial ideas – few investors can “beat the market”, and few among those who cannot can identify those who can.” Investors can achieve the highest risk-adjusted return, particularly net of investment costs such as advisory fees, by buying a full array of available stocks at the lowest fees.


All factors point to continued growth in passive investing. Its share of stock ownership, voting power and investment flows will predominate in the next several years.


For capital markets this is unfamiliar terrain.


Like all things that start out small but become very large, size itself can be a problem. Not all the consequences of passive predominance are positive.


One concern is that passive investing may weaken corporate governance. After all a passive fund manager has little motive to act if a company CEO is underperforming or is overpaid. The passive fund can’t sell the stock anyway. Some academics have demonstrated a link between higher passive share ownership and lower company value.


Another problem is the increasing concentration of voting power over American corporations by the Giant Three: Vanguard, Blackrock and State Street, who control over 80% of index fund assets. One study suggests that control is already around 25% of the votes on most routine company matters, a level considered ‘pivotal’. A small number of people who own or manage these index firms have effective control over these votes.


The father of index investing himself, Jack Bogle, wrote recently in The Wall Street Journal: “a handful of giant institutional investors will one day hold voting control of virtually every large US corporation. Public policy cannot ignore this growing dominance, and consider its impact on the financial markets, corporate governance and regulation.”


As Coates writes in his essay on index fund concentration, The Problem of Twelve, conventional analyses “also neglect… the non-wealth utility derived from power”, or in other words, these individuals may enjoy the power itself, not just the financial benefits.


For investors in ETFs there is a more pressing concern. What role will ETF liquidity play during a downturn? Many ETFs have grown up in an era of relative market calm and have yet to be tested through a major downturn.


In cases such as high yield (formerly known as junk bond), emerging market debt, or small cap equity ETFs, the liquidity of the ETF shares belies the lack of liquidity of the underlying assets in the fund. In these instances large selling of ETF shares could cause very sharp declines in the prices of the underlying assets.

This could be amplified if the “authorized participants”, or ETF market makers, step away or widen the quotes they provide. The Financial Stability Oversight Council has noted that “the ETF arbitrage mechanism is vulnerable to breakdowns in severe market stress”.


An even more fundamental question about passive investing has stirred passionate debate, but yielded no satisfactory answers as yet.


If passive investment flows dominate the market, are there enough participants making informed, rational investment decisions about the intrinsic value of individual securities to preserve the orderly functioning of the market? What becomes of the market’s all-important price discovery mechanism in the passive investment era?


Traditionally investors bought and sold a security based on their respective estimates of that security’s fair value. This supply and demand established a market price for the shares and an implied value for the firm as a whole, in other words the company’s “size”. Size, in its turn, determined that firm’s weight in the index to which passive funds benchmark themselves.


In this new world that process is reversed.


Passive investing has one primary decision rule: size. The larger the firm, the bigger its representation in the index and the more the passive fund must buy. In theory, if passive investors predominate then size becomes the key driver of a security’s price, which in turn determines the firm’s value and thus size.

The price discovery process becomes like trying to climb Escher’s staircase.


At what level of passive ownership relative to active ownership we enter that world is not clear, but it seems we are eventually going to find out.


When talking about the efficient market theory, but which could be applied to passive investing, Warren Buffet once wrote: “In any sort of contest – financial, mental, or physical – it’s an enormous advantage to have opponents who have been taught that it’s useless to even try”.


For those investors with the time, skills and inclination to analyze and evaluate individual securities, the rise of passive investment strategies may, in time, throw up attractive investment opportunities. It is not impossible to beat the market. The problem for individual investors is that the chances of finding an advisor or manager who can, consistently, are slim indeed.


Individual investors should stick with the low-cost passive approach for liquid asset classes like large- or mid-cap US and developed market equities. Take care when looking at small cap equity, corporate, high yield or emerging market bonds, or other more exotic ETFs.

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