To critics of the $11 trillion passive boom, active management is the original form of ethical investing—and time is running out to save it from the indexing onslaught.
“On a societal basis, it’s potentially disastrous,” says Michael Green, chief strategist at Simplify Asset Management, referring to the passive frenzy. “There’s an impending crisis that requires people to make changes.”
Fifty years since the first fund was created to mimic the moves of an entire market, naysayers fear the industry is now so big it threatens the capitalist social order.
Yes, it lowered costs, brought investing to the masses and improved returns for many. But the dark side according to the critics: It’s funneling money to undeserving businesses, distorting price discovery and intensifying volatility.
“Markets are ultimately not about funding someone else’s retirement but instead about allocating capital efficiently within an economy and creating the signals that encourage investment in the better companies,” says Green.
His fears over the demise of stock picking are shared by a vocal contingent in full knowledge they’re likely fighting a losing battle.
Inigo Fraser Jenkins, head of global quantitative strategy at Sanford C. Bernstein, once declared passive investing to be worse than Marxism. Michael Burry of “The Big Short” fame tweeted that “passive investing’s IQ drain” is fueling a stock bubble. Yves Choueifaty, a Frenchman known for his $10 billion “anti-benchmark” strategies, once called it “completely toxic.”
Yet investors are pouring billions into index-trackers for good reason: Evidence keeps showing that most active managers fail to beat their benchmarks after fees, while those who do struggle to maintain that performance.
Cue three lines of critique over the unintended consequences, mostly leveled at the predominant form of indexing which weights gauges based on a company’s market capitalization.
First, it creates economies of scale that concentrate equity ownership in a handful of passive giants like BlackRock Inc. and Vanguard Group. (One academic estimate suggests the three biggest money managers could cast as much as 40% of the votes in S&P 500 stocks within two decades.) Second, it will ultimately be bad for investors when the largest stocks start to underperform. And third, it’s distorting share prices.
That last point is a hotly debated issue. One point Green likes to make is passive has made markets more volatile. In a paper last year, academics Xavier Gabaix and Ralph Koijen argued that the dominance of price-insensitive shareholders—which tend to include index funds—means that $1 of inflows can lead to $5 more in aggregate market value.
To the likes of Green, that’s why stocks are posting massive moves more often in recent years between bouts of eerie calm, a phenomenon documented by strategists at Bank of America Corp. and Societe Generale SA.
Another implication is that if flows are moving prices, the latter don’t just reflect all the information about the present value of future dividends—as suggested by the efficient-markets hypothesis.