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The Rise (and Fall) of Passive Investing

In the last few years, we have witnessed the fast and furious rise of passive trackers or Exchange Traded Funds (ETFs) as the tool of preference for many individual investors.

The case in their favor is simple: most active money managers have had trouble beating benchmarks consistently and many individual investors have had decreasing success in stock picking.  It follows then that a passive tracker that ensures diversified exposure to an index at a very attractive expense ratio must be a superior choice.

In the last few years of momentum type of market action, this dynamic has been exceptionally successful.  Many active money managers, including some famous Masters of the Universe, have not been able to compete with trackers.

One reason for such success stands in the modern structure of the market and the circular logic that goes with it.  As the market has become more and more institutionalized and therefore driven by institutional funds, the benchmarks have come to represent average active money management but with much lower fees. As the Financial Times recently pointed out on the subject, this is a mathematical necessity.  This situation also accelerates the process of reinforcement as more money flows into passive trackers.

However, as much as it would please John Bogle, founder of Vanguard and father of passive investing, a world made of only passive investments would collapse.  Inefficiencies will start creeping into markets as incentives for independent research would disappear and eventually, in the most extreme of all cases, markets would stop functioning altogether.

It is somewhere in between the initial success of passive investing and the ultimate negative scenario that we find what the Financial Times calls “Peak Passive,” or that point beyond which money flowing into ETFs starts creating distortions and inefficiencies.  Whether we have reached that point or not is hard to say but we might be getting close.  There is available research (among others work by Vincent Deluard) that shows how many stocks that are included in more indexes are favored by higher valuations when compared to very similar companies not included in the same indexes.  Deluard has also found that returns of stocks included in indexes are generally higher than those of outside stocks.  This might be the case because many of our indexes are well built but some “Peak Passive” effect certainly has something to to do with it as well.

Interestingly, in 2017, based on Deluard’s work some of these relationships started to change and stocks less owned by indexes have begun to outperformed.  This is consistent with a decrease in correlations among stocks, a fact we have identified as well.

Ultimately, as we have often argued in our research, there are times and situation when passive is the most efficient choice and times when alpha should be the preferred vehicle. Of course the trick is to identify when to switch……