🔋Passive Aggressive
Is passive indexing really all it’s cracked up to be?
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In All In pt. 1, I discussed the move into passive investing and how it has shown beneficial results backtested over the last 20-plus years. This idea clashes with active managers, who have largely offered their own passive-style ETFs and capitulated to chasing large indexed stocks. With the successful investing strategy “solved”, Americans now have the largest share of wealth tied up in equities in history. This of course is a dangerous game if the market undergoes a serious bear market once again.
In All In pt. 2, I discuss the contentious topic of passive index flows (think 401k contributions). The mainstream theory is that money passively indexed into the S&P 500 does not contribute to changing the stock price and the market is efficient to any dislocations that may occur. It is naive to think that passive flows do not affect market prices when they now make up 30-40% of all inflows(range is anywhere from 25-55%). The figure below is about 25% today which may be one of the lower estimates, but shows the trend very well.
In the efficient market world, inflows into a stock should be proportional to its market cap increase. The real example used in All In pt. 2 was from portfolio manager Mike Green. Nvidia had a market cap increase of $225 billion during overnight trading off only $5 billion in trading volume. Assuming the efficient market hypothesis, this dislocation would quickly be realized by the market and promptly corrected. Back in reality, the stock has kept getting bid higher, and next week’s 401k contribution kept buying the stock at the artificially high price no matter what. This phantom market cap should have quickly corrected but it didn’t.
This is true for the S&P 500 as a whole and not just Nvidia even though the index fund is weighted and those weights don’t change regardless of the passive flows. Under the efficient market what I’m saying isn’t true, which is a common argument found to explain why not to worry about passive.
Perhaps you don't understand. If someone adds $1,000 to the stock market, all else equal, the stock market value goes up by $1000. That means a total stock index fund is worth more. As a passive investor in the total market, I don't care which stocks go up. It doesn't matter. - Rick Ferri on X
What we see is fundamentally different, however. The market cap of the S&P 500 has increased upwards of $15 trillion over the past year (other estimates around $10 trillion). Does this mean that $10-15 trillion dollars flowed into the stock market in one year?
So globally we have invested $15T into the stock market in the last year? No, try about $300B of net inflows and $800B of buybacks of which $100B went back out as dividends and roughly double that in stock compensation. - Mike Green on X
This is of course not the case. Roughly $800 billion in inflows generated a $10-15 trillion dollar increase in market cap. Why haven’t people observed this dislocation and acted accordingly to take advantage? Because 40% of inflows by mandate in retirement funds are legally obligated NOT to care. The rest of the active managers are either chasing the same stocks adding to the problem or have been getting terrible returns by sitting in cash and not chasing the stock market performance for the past 15 years and have given up the active approach.
This is an issue of market fragility and sustainability. With some wake-up call in the market or reversal in these passive inflows, it could lead to a large correction or bear market in stocks. With record household wealth tied up in equities, I fear the risk uneducated investors are taking and being told is a good investment strategy (even if it has worked for 15 years).
One final thought is you should also ask yourself why the stock market is having the best returns in history with negative net inflows into equity funds. If equity funds are net sellers, then who is the buyer and how are prices going up?
I will cover the staggering answer next week. Until then,
-Grayson
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