The year the year is 2034. America’s “magnificent seven” companies make up almost the entire country’s stock market. For Nvidia boss Jensen Huang, another knockout quarterly profit marks another staggering announcement of a “tipping point” in artificial intelligence. Nobody listens. The long rise of passive investing has put the last stock pickers and stock watchers out of work. Index mutual funds and exchange traded funds (ETFs) – who buy a number of stocks rather than guessing which ones will perform best – completely dominate the markets. The big questions of capitalism are being discussed in private between a few technology bosses and asset managers.
In reality, the dystopia would likely be avoided: the markets would cease to function after the last wayward investor turned out the lights. However, that hasn’t stopped academics, fund managers and regulators from worrying about thoughtless money, especially in times of market mania. After the dot-com bubble burst in 2000, Jean-Claude Trichet, a French central banker, included passive investments in his list of reasons why asset prices could break away from their economic fundamentals. Index funds, he argued, were able to “create performance rather than measure it.” Red-hot US markets have brought similar arguments back to the fore. Some analysts point the finger at passive investing for inflating the value of stocks. Others predict its decline.
Such critics may have a point, even if some are prone to exaggeration. It seems likely that there is a link between the concentration of value in the US stock market and its increasingly passive ownership. The five largest companies in the S&P 500 now make up a quarter of the index. In this area, markets have not been this concentrated since the “Nifty Fifties” bubble of the early 1970s. Last year, the size of passive funds exceeded active funds for the first time (see chart). The biggest single ETF following the S&P 500 index has amassed more than $500 billion in assets. Even these huge figures belie the actual number of passive dollars, due in no small part to ‘closet indexing’, where apparently active managers align their investments with an index.
Index funds have their origins in the idea that emerged in the 1960s that markets are efficient. Because information is immediately “priced in,” it is difficult for stock pickers to offset higher fees by consistently beating the market. Many academics have tried to disentangle the effects of more passive buyers on prices. A recent paper by Hao Jiang, Dimitri Vayanos and Lu Zheng, a trio of finance professors, estimates that as a result of passive investing, returns on the largest U.S. stocks exceeded the market by 30 percentage points between 1996 and 2020.
The clearest victim of passive funds is active managers. According to research by GMOa fund management company, an active manager who invests evenly in 20 stocks in the S&P 500 index, and usually making the right call, would have had only a 7% chance of beating the index last year. No wonder investors send their money elsewhere. Over the past decade, the number of active funds focused on large US companies has declined by 40%. According to Bank of America, the average number of analysts covering companies in the US has increased since 1990 S&P 500 index is down 15%. Their decline means there are fewer value-oriented soldiers guarding market fundamentals.
Some now think this trend may have run its course. Students embarking on a career in value investing will consult “Security Analysis,” a stock picker’s bible written by Benjamin Graham and David Dodd, two financial academics, and first published in 1934. In a recently updated foreword by Seth Klarman, a hedge fund manager, they encounter hopeful claims that the increasing share of passive money could increase the rewards that come from studying companies’ balance sheets.
Fees charged by active managers have dropped significantly; perhaps election volatility will even help some markets outperform. A few might muster the courage to bet on market declines. If they are right, their profits will be all the greater because of their docile competition. But for now, at least, passive investors have the upper hand. And unless the concentration of the US stock market decreases, it seems unlikely that the fortunes of active managers will really turn around. ■
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