Is Passive Feeding The FAANGed Mega-Cap Beast?

It has been well documented that, over the last five years, a small number of mega-cap stocks have contributed a substantial amount to the overall U.S. market returns. The impact of these stocks, especially the FAANG and Microsoft stocks, was due to their outstanding growth and their large size relative to the U.S. market. This has also coincided with a massive industry-wide switch from actively managed funds toward passively managed funds.

According to researchers from the U.S. Federal Reserve1, as of the end of 2018, 47% of total U.S. equity fund assets were in passive funds, up from around 14% in 2005. Over the same period, overall stock ownership by passive funds (mutual funds and ETFs) increased from 4% to 14%.

That brings us to two questions:

Has passive investing helped drive the mega-cap, FAANG-led, outperformance over the last five years? And has that led to potential advantages from active management at this point in time?

Passive investing defined

To begin, we need to start with a clear definition of passive investing and understand its theoretical capability of impacting security pricing. Passive investing is a simple, cost-effective investment strategy that tries to mimic the performance of a given benchmark by purchasing securities at the same weights as the benchmark. Passive investments are generally implemented in two distinct structures: index mutual funds and ETFs. The goal of passive investing is not to outperform the benchmark but to efficiently track it at low cost. On the other hand, active investing tries to outperform a given benchmark by holding securities at different weights relative to the benchmark, based on the insights of fund managers.

Can passive investing create bubbles?

In general, the standard benchmark for passive investing is an index that tries to capture the performance of the broad market, as represented by common benchmarks such as the S&P500® large-cap index or the Russell 2000 small-cap index. Passive investing does not affect the relative weight of securities within the index. Only the cumulative action of active investors sets the prices of securities, and passive investors just go along for the free ride. For all practical purposes (with the exception of securities being added or removed from the index), in the absence of additional cashflows in or out, passive funds require no trading to track the benchmark, as the security weights automatically change as active investors reset prices based on their insights.

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