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Index funds are a favourite bogeyman of many fund managers and analysts, as the great whooooosh of money flowing from active to passive strategies has accelerated and broadened in recent years.
Goldman Sachs’ chief US equity strategist David Kostin and his team have taken a look at a few of the more common scary arguments on how this is wrecking markets, and came away . . . unconvinced.
This may surprise a lot of people, given how enormous this trend is, and the US stock market is its ground zero. As Kostin’s report notes, a cumulative $2.8tn has flowed into passive US equity funds during the past decade, while actively-managed funds have shed seen $3tn yanked out.
As a result, the median percentage of S&P 500 shares owned by passive funds has risen from 18 per cent two decades ago to 26 per cent. If you weight by dollars, 24 per cent of the S&P 500 index is now owned by passive funds.
And as Alphaville has written before, this is probably meaningfully understates the overall size of passive investing, given how much money there is in index-tracking, non-fund strategies.
It’s natural to assume this must be having all sorts of pernicious effects. How could a trend so pervasive not?
FTAV has been planning to do a proper effortpost on the topic for a while, but in the meantime here are Goldman’s takes on a few of the more common tropes, with some of our own thoughts.
💥 Does passive investing increase correlations? 💥
One of the most common anti-passive arguments is that the tsunami of “dumb” money is causing stocks to more in lockstep, eroding the supposed market efficiency that underpinned the birth of index funds.
However, Kostin points out that there’s zero evidence of this in stock market correlations. This has for generations ebbed and flowed entirely independently of the passive trend — and has in fact been generally falling over the past decade, despite the growing passive tide:
From a top-down perspective, the impact from passive ownership has not been apparent in S&P 500 stock correlations. Typically, stock correlations are low in market environments where company specific fundamentals dictate performance and are high when macro factors such as economic growth affect the entire equity market in a similar manner. A common investor concern is that demand from passive investors is not tied to company-specific factors, and as a result would cause stock returns to be less micro-driven. A time series of S&P 500 stock correlation has shown a downward trend over the past decade, and this year fell to a low of 0.08, a similar level to troughs reached in 1995, 2000, 2006, 2007, 2017, and 2018.
💥 Does passive investing drive valuations? 💥
Another popular trope is that the trillions of dollars of valuation-blind passive money is swamping fundamentals and leading a secular increase in stock market valuations, and/or cyclical bubbles such as the recent AI stock boom.
The first has always been a weak argument. The four-decade decline in interest rates is a much more compelling rationale for the four-decade increase in equity valuations. And if index funds didn’t exist, the money that has gone into them would just have gone into active funds anyway, leading to the same supposed overall valuation increase.
The second leg of the argument seems superficially more compelling. After all, most passive strategies use capitalisation-weighted indices, so some people think that the more money goes into passive funds must simply be shovelled into the biggest stocks, making them bigger and bigger.
However, this is a fundamental misunderstanding of how index funds function. If a stock goes up the fund doesn’t need to buy more because it already holds a proportional amount of it. Only new incremental dollars going into the fund would be divvied up according to any new weighting, but this would be reflective of the prices and valuations set by active managers.
And lo, Goldman has disentangled different factors and looked at how they affect valuations, and found that fundamentals remain absolutely dominant.
Across the S&P 500, we also find after controlling for fundamentals, passive ownership does not help explain any additional variation in valuation multiples. A cross-sectional regression of S&P 500 stock P/E multiples on metrics such as earnings growth expectations, duration, earnings stability, profit margins, and asset turnover shows that fundamental metrics help explain 50% of the variation in valuation multiples today. If we incorporate variation in passive ownership into this framework, it does not help explain any incremental variation across multiples. In addition, the importance of passive ownership for stock multiples, aside from not being statistically significant, is weaker than the importance of fundamentals.
💥 Is passive investing entirely passive? 💥
This is often bandied about as a silly “gotcha” question, as if the vast majority of people that use passive strategies do so only for dogmatic market-efficiency zealotry. They do it because the long-term net results both for individuals and institutions are vastly better.
The line between “active” (which has in reality often been very passive in practice) and “passive” (which, yes, is dependent on some often active decisions on index composition) has always been blurry. And that is particularly true now that ETFs are growing, as Goldman points out.
From a market structure perspective, trading in passive investment vehicles does not always reflect passive buying. During periods of high equity market volatility our options strategists have found that ETF trading volumes account for a large share of trading compared with lower volatility environments. During the past year ETF volumes accounted for 28% of the tape. Nevertheless, not all ETF trading is passive. For example, hedge funds utilize ETFs as hedges in lieu of individual stock shorts.
There are lots of valid questions that can and should be asked about index construction, and not enough people appreciate how subtle differences in decisions at S&P, FTSE Russell or MSCI can have large effects.
For example, BlackRock’s flagship US technology stock ETF includes Alphabet and Meta, while Vanguard and State Street’s do not (they are technically classified as communications companies, not information technology). Major companies are even moving their headquarters purely to attract more of the passive bid.
But as an argument against index funds this issue is pretty weak sauce, given the abysmal long term results of active funds.
💥 Does passive investing affect stock returns? 💥
This is a somewhat related but subtly distinct point from the valuation issue. But some people argue that mechanistic index fund buying can power returns, by — in practice — eating up the free float of a company. That makes its stock price move more powerfully on any incremental buying.
However, Goldman’s equity analysts examined whether stocks with higher passive ownership generated greater returns and found little discernible pattern. In fact, highly passive-owed stocks have generally underperformed for the past decade despite the powerful bull run:
S&P 500 stocks with high passive ownership have not consistently outperformed low passive ownership stocks. We construct an equalweighted sector neutral factor to test whether stocks with high passive ownership outperform counterparts with low passive ownership. Data used to compute passive ownership shares is released quarterly and reflects changes in ownership across the completed quarter. The factor is rebalanced at the start of each quarter based on data that covers the coincident quarter. Performance since 2000 has been inconsistent, stocks with higher passive ownership outperformed up until 2014 before plateauing and subsequently giving back of most of the early 2000s gains over the past 5 years.
To offer up a concrete example, you can see evidence of this in the rally of the “Magnificent Seven” stocks that have powered the US stock market over the past couple of years.
Some have argued that they have been driven by momentum-riding passive funds, but they are actually relatively less owned by passive funds than the US stock market as a whole. As FTAV has previously argued, index funds are price takers, not price makers.
It should be said that there are some more nuanced, critical analyses of passive investing coming out of academia and the finance industry recently, which we’ll go through thoroughly at some point.
There are certainly a lot of examples of how it can affect individual companies and securities — some of them pretty fun (promise). We’ve even had the first index-related insider trading case, with an S&P executive in 2022 found guilty of getting a friend to buy puts and calls on companies about to be included or relegated from influential benchmarks.
But as the latest US Weekly Kickstart report from Kostin’s team shows, one should be extremely sceptical of arguments that passive investing is affecting markets on a macro level. Not that this will stop any of the hand-wringing.
Feel free to tell us how stupid we are and why index funds are worse than the Black Death, Marxism and the Star Wars prequels in the comments.
Further reading:
— Super passive goes ballistic; active is atrocious (FTAV)
— Passive attack: the story of a Wall Street revolution (FT)