The surge in passive investing is raising concerns across Wall Street about potential market distortions. With index funds attracting significant inflows while active funds experience outflows, prominent firms like Apollo Global Management and Citadel have voiced criticisms, blaming passive investing for diminishing the role of active stock pickers in maintaining market efficiency.
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Wall Street Banks Defend Passive Investing
Goldman Sachs and Citigroup offer counterarguments to these criticisms. A Goldman Sachs study indicates that fundamental factors, such as earnings stability, remain the primary drivers of stock valuations, downplaying the influence of passive investing. Citigroup’s research suggests that active managers themselves have a greater impact on a stock’s performance relative to its industry than their passive counterparts. This challenges claims that passive investors are uniquely distorting asset prices.
Chart showing the growth of passive investing
The Rise of Passive Investing and Market Concentration
The ongoing debate coincides with the increasing dominance of passive exchange-traded funds (ETFs), which now comprise 62% of US equity fund assets, up from 35% a decade ago. This growth correlates with an increasingly concentrated equity market, where a handful of large technology companies, often referred to as the “Magnificent Seven,” continue to gain market share. Critics argue this concentration demonstrates how passive investing is altering market dynamics, potentially leaving undervalued stocks without natural buyers. This has led to a significant valuation gap between cheap and expensive stocks.
Examining the Role of Fundamentals vs. Passive Ownership
Apollo attributes the rise of the Magnificent Seven and other market issues, such as increased volatility and reduced liquidity, to the fervor for passive investing. However, Goldman Sachs refutes this claim, highlighting that the Magnificent Seven generally have lower passive ownership than other S&P 500 companies. Their research emphasizes the importance of fundamentals, like earnings growth expectations and asset turnover, in explaining valuation variations, while finding no discernible impact from passive ownership.
Chart comparing the performance of growth and value stocks
Citigroup’s analysis further supports this view, demonstrating that stock returns relative to industry peers are more influenced by active buying than passive investing. They conclude that index funds, despite their increased market share, act as “tailwinds for, not determinants of” share performance.
The Blurred Lines Between Active and Passive
While short-term market dislocations can be attributed to discretionary buyers, the distinction between active and passive investing isn’t always clear-cut. Even within passive strategies, human judgment is involved in designing investment rules and executing trades. The inclusion of Super Micro Computer Inc. in major benchmarks, following a surge driven by day traders and institutional investors, exemplifies this complexity. While passive demand likely contributed to the runup, the decision to include the stock in the indexes was made by a committee.
The Importance of Active Management for Market Health
The declining number of active managers raises concerns about long-term market health. These investors are crucial for identifying market mispricing and ensuring efficient capital allocation. Some argue that regulators undervalue the role of active managers, potentially overlooking a significant financial stability risk. The core principle of passive investing relies on the price efficiency created by active managers competing and trading against each other. Therefore, maintaining a certain level of active management is considered essential for the overall health and efficiency of the market.
Conclusion
The debate surrounding the impact of passive investing on market efficiency is far from settled. While critics point to potential distortions and the rise of market concentration, prominent financial institutions counter that fundamental factors remain paramount. As passive investing continues to grow, understanding its complex interplay with active management and overall market dynamics remains critical for investors and regulators alike. The long-term implications of this shift in investment strategies warrant continued scrutiny and analysis.
