Passive investing or investing in index funds has gained significant share over the past few decades at the expense of active funds (or funds which try and beat the market). Indeed, the rise in passive investing has also stemmed from the fact that increasingly a higher share of active fund managers are struggling to beat the market. However, passive investing has attracted criticism unsurprisingly from some active managers. Their gripe is because passive investors have no opinion about value of the underlying security (as they simply buy the index constituents in the same proportion as the weights in the index), this distorts the market structure by suppressing price discovery. A market is meant to be a reflection of the collective intelligence of all market participants, most of whom presumably have an opinion of value. Here is an essay in response to such criticism and in defence of passive investing. It begins:

“Since passive investors mostly do not trade, it is mostly true that they do not impact market prices; what really matters is what the non-passive investors are doing. Now, I say “mostly true” because there are complicated mechanisms through which the presence or absence of passive investors may impact prices, but the key thing about passive investors is that they do not trade. As we say in the homicide squad, “no body, no crime,” and here we have “no trade, no crime.”

So effectively, the author suggests that as long as there are active investors in the market (doesn’t matter what percentage of the market), the sanctity of the market is protected as price discovery continues with passive investors having no effect.

“There has been much handwringing about the fraction of the market that has become passive. Should we be alarmed if it is more than 50%? What about 90%? Surely Congress should step in and outlaw indexing if passive rises above 95%?

No. There is no magic number, other than 100%, at which the market suddenly flips to being dysfunctional due to passive ownership. What matters is the existence of a sufficient number of informed active investors with a sufficient number of dollars and the existence of a liquid market with multiple types of interacting traders. As long as those conditions hold, you can have a well-functioning, efficient market with informative prices, and it doesn’t matter whether passive is 1% or 99% of the market.”

The key criticism of passive investing that the author is arguing against is summed up by this quote from John Authers of Bloomberg:

The problem with passive funds is that as long as they’re taking in new money, they’ll accept the prices then available in the market. Thus, the more a company is valued, the more the fund will buy of that company, tending to push the price up further. With tech performing well anyway, the argument is that the weight of money coming into passive funds each month will add to the sector’s momentum, bringing it further and further away from the rest.

To which the author responds:

“If an S&P 500 index fund receives inflows, the fund buys x% of the shares outstanding of both McDonald’s and Nvidia. You’d expect both stocks to rise the same percentage amount. Now, maybe you could argue that McDonald’s and Nvidia have different price elasticities, but that is a different mechanism. You could also argue that all S&P 500 stocks will become overpriced, but that is a statement about narrow indexing, not about the momentum of tech stocks.”

The author gives a couple of analogies to drive home his point before concluding the essay with views from the academic world on the subject such as this one…

“Garleanu and Pedersen (2022) say passive makes the market more inefficient, and that this inefficiency helps active managers to outperform:

Another trend over the past decades is the decline in the cost of passive management. We show that such a decline should lead to a rise in passive management (at the expense of self-directed investment and active management), consistent with the development in the 2000s… Further, a reduced cost of passive management leads to an increase in market inefficiency… leading to stronger performance of active… These predictions are consistent with the empirical findings…”

…before concluding:

“…the academic consensus is as clear as mud. Passive investing either makes relative pricing more efficient, less efficient, or has no effect. One common thread to many models, however, is that as passive investing goes up, informed active investors should benefit, which has not been the case in recent years.

So where does that leave us? In a healthy market, we need some smart active investors, including smart fundamental investors like Einhorn and smart systematic investors like Acadian Asset Management. We also need some non-smart non-passive investors for the smart people to trade with; such traders appear plentiful. Yes, it is true that the passive investors are benefiting from the efforts of smart investors, but they are not necessarily making life worse.”

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