Will Passive Investing Break The Stock Market?

 I don't have the answer to the question appearing above, but many people, including myself, feel this could certainly happen. The trend away from active management and to what's known as passive investing has been ongoing for some time, but in the past decade or two, it has relentlessly picked up steam. With a market share approaching 50%, passive investment vehicles have attained 800-pound gorilla status.

What is passive investing? Simply put, passive funds are funds whose investment securities are not chosen by a portfolio manager. Instead, they are automatically selected to match an index or part of the market. There are two main types of passive investment vehicles: index mutual funds and exchange-traded funds (ETFs). Proponents of passive investing stress the general outperformance in returns compared to the majority of active managers. To date, this claim is accurate. Part of the reason for the superior returns is that the fees charged are much less for passive mutual funds and ETFs.

There is, however, a dark and potentially dangerous side to passive investing. First, it should be noted that passive investing is far from passive. Passive investors continually buy and sell as new money enters the market and old money leaves the market. New companies enter the market in the form of IPOs while old companies leave the market due to mergers and acquisitions. Indices routinely rebalance and reconstitute their holdings. As such, passive is active. This type of investing has allowed a system to persist that mechanically inflates valuations. It is also a mindless, systemic activity. Passive investors have no interest in the fundamentals of the stocks they purchase. By throwing money at all companies within an index, investors distort company valuations, capital flows, and stock prices. The proportion of price-insensitive market participants has increased which in turn has increased the inelasticity of the market - the ability for prices to change in response to relatively small changes in supply and demand. An important historical filter is being removed from the market.

The largest companies are the least elastic. As they get bigger, the index becomes concentrated among those behemoths. The indices themselves and the market, in general, are becoming significantly less elastic. The top 10 biggest stocks account for more than 36% of the total value of the S&P 500. The five largest companies amount to 27% of this index. And most concerning, the three largest stocks in the S&P 500 - Microsoft, Apple, and Nvidia, make up nearly 21% of its total market value. The argument can be made that passive investing has evolved into a massive momentum-based strategy that arbitrarily pushes up (or down) the prices and valuations of companies in cap-weighted indices. This correlation between market valuations and the flows of passive money will increase in proportion to the volume of passive money in the market.

The United States enjoyed a head start in the passive investment movement and is further along in passive investing than any other market around the world. This helps explain why we ultimately continued to gain share versus the rest of the world. It should come as no surprise that the likes of Blackrock, Vanguard, and State Street led the push to passive investing with their extensive lobbying efforts. A big change came in the aftermath of the Pension Protection Act of 2006. In this bill, 401(k) plans were switched from an opt-in to an opt-out framework. In other words, an employee had to specifically choose not to participate in his employer's defined contribution plan. Another major change at that time was the designation of qualified default investment alternatives, which directed savers to index funds. One can make a persuasive case for how this law and other regulatory changes have corrupted the equilibrium and signaling mechanisms of modern markets.

Although our GDP doesn't support the long-running bull market, the combination of massive government stimulus and passive investing will continue to expand the general asset bubble. Never has the health of the economy and the health of the stock market been so out of sync. You have 100 million Americans who believe their "deposits" in the S&P 500 are safe. I believe they are in for a rude awakening. The world can suddenly change in quite a dramatic fashion. History is replete with market sell-offs, some of great note. I'm not about to make a timing prediction, but mark my words, a Black Swan event, whether it be a financial crisis, a pandemic, a geopolitical conflict, or something entirely novel, the excrement will eventually hit the fan again. On average, the S&P 500 drops over 30% about once every seven years.

A bull market normally ends violently with a bang. At times the equities market simply withers and slowly slides to a point where investors lose a sizeable chunk of their net worth. Models suggest markets are increasingly reliant on employment and the contribution to various 401(k) plans. Job losses attributable to a Recession could reverse passive flows and trigger selling followed by flows out to cover investors' living expenses. Another possible scenario would be Baby Boomers beginning to take out substantial amounts of money from the markets during their retirement years. Demographics are always relevant and at some point, passive investors become net sellers and require liquidity. Ultimately you end up seeing a net redemption that plays the whole value appreciation in reverse. The large index funds hold very little cash. For example, the Vanguard total market index fund is a $1.6 trillion fund with only $80 million in cash. Even a relatively modest amount of negative flow as people request withdrawals from the fund would cause Vanguard to seek liquidity by converting from a net buyer to a net seller.

As mentioned previously, the timing of stock market tumbles is practically impossible to predict. Very few investors are smart enough, or more likely lucky enough, to nail these predictions. Another variable has also entered the scene starting with the Great Financial Crisis (2008-2009). The U.S. stock market in many respects has become the nation's retirement system. In a crisis, the government will feel they can't allow this retirement system to fail. They will intervene aggressively. Measures will be taken to save the system, at least in nominal terms, and thus the can will be kicked, again. However, the buying power of our currency will be further diminished on its way to oblivion.