Passive goes massive – and what it means for portfolios

Passive funds, including ETFs could exceed 50% of the US equity market by the end of the year, according to Nicolas Firzli, director of the G7 Pensions Summit.

At present, according to his data, they account for between 47% to 48% of the total, while passive institutional ownership in North America, Europe and Asia-Pacific is 40%.

The wisdom of crowds has become increasingly dumb

Inflows into passive funds have continued through the Covid-19 pandemic. In March 2019, Bank of America Merrill Lynch said passive funds were 45% of the US total. 

Asset managers led by BlackRock and Vanguard continue to attract followers by launching a stream of passive funds. Vincent Deluard, director of global macro at StoneX, says there are now more ETFs than the total number of stocks on the New York Stock Exchange and Nasdaq. 

Firzli, an adviser to the World Bank, reckons capitalism could be turned on its head through the rise of passive investing, as the indices exert greater, leverage over investment decisions. The market is becoming less efficient, as the influence of active managers on share prices steadily wanes.

He says: “Let’s be clear passive investments are neither ‘good’ nor ‘bad’… but above a certain threshold- and that threshold has already been reached for US large caps – they run the risk of amplifying traditional benchmarking.”

Active managers allocate their money with two purposes in mind. One purpose is to outperform. The other is to avoid the risk of being sacked.

They make an effort to pick stocks capable of performing well. But they are now adding more stocks with a high index weighting to their portfolio, as an insurance policy which limits their risk of underperforming against cheap passive funds. They frequently allocate to large-cap quality growth stocks, like Apple and Microsoft, which have been driving the index, and vice versa, for years. 

Tech disruption is an important theme for their overall performance but other factors have helped. For example, growth stocks have been boosted by the popularity of healthcare and technology ETFs, plus mutual funds which take a positive view of tech. Examples would be ETFs Powershares Nasdaq, Healthcare Select SPDR and an assortment of FANG+ indices. 

During the Covid-19 pandemic, large tech stocks have become a defensive as well as an offensive play due to the belief that an economic revival requires tech-driven solutions. StoneX’s Deluard has calculated that stocks which have a decent weighting in several indices get a further pricing boost. A few, like Amazon and Apple, benefit from a relatively small float of shares in issue.

Less fortunate old economy companies, notably small caps, eke out their living in the shadows. The gap in performance between US value and growth, as measured by the Russell 3000 index series, is even greater than at the peak of the dotcom bubble of 2000. 

The few remaining value funds continue to be trashed, leading to the departure of old economy managers whose safety-first approach is no longer viewed safe. 

New managers taking the helm almost always take a more pragmatic view. Some even try to reinvent value investing, by paying more attention to cash flow and less to the strength of underlying balance sheets, which produces another tilt towards the index. 

Growth stocks also gain strength from the Federal Reserve’s zero-bound interest rate stimulus which is boosting growth, just as it did in early 2000. When markets drop, equities even get support from passive target-date funds, worth $2.3 trillion, managed by the likes of Vanguard, which invest in a mixture of bonds and equities and rebalance into equity indices when they perform badly.

All this means the market is becoming less efficient as attempts by active managers lose conviction and get swamped.  We are getting higher than normal valuations for certain stocks which do not trouble passive investors. We are seeing lower market volatility because passive managers continue to enjoy inflows and turn over portfolios relatively slowly. 

The wisdom of crowds has become increasingly dumb. And the biggest gainers are likely to be private equity funds, companies and family businesses with access to cheap capital who can pick off supine bid targets neglected by the market, at their leisure.