Is Passive Feeding The FAANGed Mega-Cap Beast?

This leads to our first point: Passive investing, by definition, cannot create bubbles (or relative mispricing) within an index.

Passive investing could only create bubbles if the underlying index is focused on a subset of the marketable universe of securities. However, a large portion of passive investments are benchmarked to broad market indices. For example, the nine largest ETFs and index mutual funds—representing approximately $2.7 trillion in assets as of December 2019 and over 60% of passive U.S. equity investments—are benchmarked to broad market indices, such as the S&P 500® Index and CRSP U.S. Total Market Index. These cover approximately 80% and 99% of the investable U.S. equity market, respectively.2

Can passive investing perpetuate bubbles?

A follow-up question must be asked: If passive investing cannot create bubbles, can it perpetuate bubbles by making it difficult for active managers to reset prices? Certainly, if passive investing became 100% of the market, there would be no investors left to change the relative valuation of securities. But even with the significant reallocation from active to passive strategies, active investing is still approximately 50% of the fund market in the U.S. This is a large enough percentage to take advantage of perceived security mispricing and reset prices in the market. Also, as stated earlier, only approximately 14% of total stock holdings are held by passive funds. If passive investing dominated the U.S. equity market, we would expect to see intra-index correlations between securities go to one, as they all move together.

The following chart shows the average correlation between securities in the S&P 500 Index over the last 16 years. There does not appear to be a discernable pattern that correlates with the increase in passive investing.

(Click on image to enlarge)

SP 500 rolling index

Source: Russell Investments, S&P

This leads to our second point: Passive investing can only perpetuate bubbles if it is the overwhelming majority of the market.

While this is not currently the case, another consideration is that active managers do have an incentive to limit the amount of risk they take on by deviating from their benchmark. So, even though actively managed funds might represent a large portion of the market, their ability to change relative pricing might be limited by risk constraints.

Will passive investing make market selloffs worse?

While there are few observations of sizable selloffs since the large shift to passive, a couple of points can be made. First, if investors switch out of equities and into another asset class such as cash, selling passive investments will proportionally sell the same amount of every security in the index. Given that the securities are weighted by their market-cap, it should not cause an outsized impact on any security relative to another (assuming liquidity is approximately linear to market-cap). Second, if a specific set of securities is reweighted by active investors, the index will automatically adjust, and passive funds will not need to trade.

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Disclosures

These views are subject to change at any time based upon market or other conditions and are current as of the date at the top of the page.

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