Stockholm (Ekonamik) – “It seems only a matter of time until index mutual funds cross the 50% mark [of corporate share ownership],” John Bogle, founder of Vanguard and inventor of passive investing wrote in a guest column for the Wall Street Journal at the end of 2018. “If that were to happen, the ‘Big Three’ [Vanguard, BlackRock and State Street Global Advisors] might own 30% or more of the US stock market— effective control. I do not believe that such concentration would serve the national interest,” he warned.
The ETF industry, as an alternative to indexed mutual funds, is an important vehicle for passive investing and as such a constituent part of the problem discussed by Bogle. Given our thematic focus this week, I wanted to get a sense of where we stand in this race and what the role of ETFs is.
The Roots of Passive Investing
The roots of passive investments can be traced back to the work of Nobel Laureates Eugene Fama and Paul Samuelson and to the asset management entrepreneurialism of John Bogle.
Following the publication of Eugene Fama’s description of the Efficient Market Hypothesis in 1965, Paul Samuelson in his 1974 “Challenge to Judgment” article in The Journal of Portfolio Management, challenged the economic profession to set up a fund that tracked a market to test the hypothesis that the market could not be beaten. The year after, John Bogle set up Vanguard.
The Stock of Passive Investments and of ETFs
To my surprise, it turns out that sizing this up is not as straight forward as I had expected. Once again, it seems that different sources have disparate estimates and often non-overlapping perspectives.
At the end of last year, Morningstar warned that the tipping point where passive funds outpace active investors will be reached in 2019. According to data from Morningstar, passive funds were worth US$ 3.9 trillion at the end of 2018, up from US$ 3.6 trillion the previous year. Moody’s, on the other hand, warns that passive funds will represent 25% of the market by 2025 only.
According to the Investment Company Institute’s (ICI) Fact Book for 2019, ETFs attracted US$311 billion in capital from investors in 2018, down from a record inflow of US$471 billion in 2017, pushing the total amount of ETF holdings to US$3.4 trillion. The ICI also reports that of the US$18 trillion in total net assets of the Fund Market in 2018, Index ETFs and index mutual funds represent 18% each. Index domestic equity mutual funds and ETFs represent 13% of US stock market capitalization. Based on these figures we can say with some degree of confidence that the stock of passive investments amounts to 36% of the total stock of fund investment amounting to US$ 3.24 trillion.
The Dangers of Passive Investments
The main danger of passive investing is also their main advantage. As they are entirely tied to a market they suffer from total market risk. Should the market crash, they will do along with it. Moreover, they also increase correlation as the funds will buy and hold the relevant share of stocks in that market at any given moment. One of the results is that passive investing tends to lead to herd behaviour which exacerbates bubbles and crashes.
An interesting example of this concern was recently expressed by Bill Smead, founder of US value investment firm Smead Capital, who pointed at the impact of the strategy on poor IPO performance. “Many are wondering why the market for initial public offerings has performed so poorly, even though the flood of hot new ones came to market recently. It took three years to choke demand for money-losing dot-com IPO companies back in 1997.” The development of passive investing has changed this. “Indexing provided by funds and exchange-traded funds like Vanguard have well over 50% of U.S. large-cap stock ownership, while sector ETFs and growth stock funds and ETFs own a very large part of the rest. Even value-oriented stock-picking organizations feel the pressure to mimic the indexes by piling into their largest tech favorites. It is called job security and they feel they must do this to survive.”
“The irony of indexing is that the rich get richer. The bigger you get, the bigger you get in the index. The more popular the index gets, the more money which pours into the already popular stocks. Unfortunately, this virtuous circle will become a negative feedback loop in the next bear market. The historical precursor of which has been the golden goose of excitement around newly public merchandise,” he concludes.
We should not be surprised to hear active managers attack this strategy, which undermines their entire business model. However, that is not in and of itself a reason to ignore the concerns they point out. “Passive indices can contain unwelcome biases and hidden concentration risks, while also increasing investors’ exposure to wider systemic risk,” Alistair Jones, UK Strategic Solutions at Schroders argues.
These concerns are not new. It is also worth remembering – if only for its entertainment value – that when John Bogle started marketing passive funds in the late 1970s active managers called the new investment approach “Marxist”, which might have more to do with the specificities of that time. Nevertheless, the stigma remains among.
Impact at the Margins
Vanguard subsequently struck back against Smead correcting the market share figure from 50% to 15% and noting that “Indexing strategies have low turnover and account for about 5% of daily trading volume, with other market participants (active managers, retail investors, high-frequency traders, pension funds) accounting for the vast majority of trading volume. ‘As a result, “active” market participants play a dominant role in security trading and price discovery, not index strategies.
However, the correction seems somewhat hollow in light of John Bogle’s own concerns. As we approach the end of this economic cycle it will be interesting to see how markets perform and what role passive investments will play in the unfolding of financial and economic conditions.
Picture from Pixabay