6 Sharp Investors Walk Into the Passive Investing Bar ...

Yes, Passive impacts markets. So what?

I was excited with the supersmart Jack Forehand and the Cultishly Creative Matt Zeigler asked me to join them on their booming podcast, Excess Returns, and this article is a bit of a companion piece, but you can watch or ignore the actual podcast at your leisure:

How did *I* get invited? Because I write about passive now and then, and I’m obsessively rabbithole about it. For the sake of brevity I will not repeat the entirety of the “Active/Passive Argument” but I wrote about it a few months ago if you’d like a Primer.

The format of this show (which I adore) is a “clip show” where they collect comments from past shows, and we have a conversation about it. So here are the 6 clips we’re discussing, and my reactions (which I probably said out loud too, but some people {hand up} like reading. Plus charts. Video optional.)

Aswath Damodaran, NYU Stern

“Active investing has always been crappy, but for much of it’s lifetime we didn’t know how crappy it was… As passive investing grows, it will hit a cap… If too few people are looking for mistakes, you can argue the magnitude of mistakes will get larger, and that active investing will pay off again.”

SPIVA is on this. Thank you S&P. Active investing is indeed crappy.

Check out the left hand set of bars. This is the percent of actively managed large cap US equity funds that failed to beat their benchmark, the left most column is 1H24, the right most column is 20 years. 57% of active funds underperformed over the first half — and that’s a very good 6 months historically. Of course, if you slide over to small caps you can see that over the last year, active small cap has been a lot better! Over the last year, only 37% underperformed! Honestly, still not GREAT odds you picked just the right manager.

Mike Green, Simplify

“Anytime a flow is contributed, that makes you not-passive... Were creating a distortion in the market that is tied to the growth of passive, that is changing the actual features and behaviors of the market itself. You can argue those are good, or you can argue those are bad...”

Mike points out the two potential “So What, Big Deal” issues:

1: Were hampering the utility of markets as tools of actual capital allocation. After all, the point of markets is to get money where it will be most useful, ideally for overall growth and societal gain. “Buying everything” doesn’t allocate to the best companies, best ideas, or best people. But it DOES make the market as a whole go up.

2: Lack of liquidity when everyone wants to sell. I’m less of a believer on this one, although there’s a key and important point: Someone has to buy, when people want to sell, and if what you want to sell is “the market” then you have to find someone willing to be in, while you want to be out.

That sounds silly, but selling your AAPL shares is a lot easier, because chances are there’s someone out there who will say “fine, I will buy your AAPL cheap because I can sell some MSFT. That’s the main reason for index inelasticity — there aren’t clear substations.

Rick Ferri, Ferri Investment Solutions

“There’s no evidence of this at all. If you look at dispersion of S&P 500 stocks … it hasn’t changed in 50 years. Indexing isn’t doing anything to the market.”

Here’s a good paper on concentration and dispersion by SSGA, where they make a pretty straightforward point:

More dispersion means more opportunity for active managers. An interesting question is: if the dispersion effects are short lived (certainly intra-month, and often intra-day) then this active management opportunity is also likely equally short lived. This is another key point that I think folks miss: long term investors buying SPY have different market impacts than short-term traders using derivatives, and all that information goes into the same tick-by-tick price discovery. And importantly, both are heavily indexed.

Rick is, I think, just wrong in his thinking that passive has had no effect. He’s not wrong when he says that the average individual shouldn’t give a hoot about this. But if your in the business of managing money or working on policy, it’s absolutely worth paying attention to, especially at shorter durations where it’s almost all about options now. From a great summary on current markets from LSEG: roughly 25 Trillion in notional on ETFs and Indexes.

Cem Karsan, Kai Volatility Advisors

“There’s a natural momentum factor to passive investing… Tell me what’s gonna happen if we have a 15 year period (like 1968-1982) where the market net-net goes nowhere, and in real terms loses 70% of its value... If we’re right, and that happens, what happens to passive investing? I think its going to change. We’ll have passive investing, but more passive investing in active vehicles.”

What Cem is skipping over a bit here, but covers almost daily in his seemingly non-stop media appearances, is the impact of options market activity — structural flow — on actual index pricing. It’s well established in the literature that market maker activity “pins” the index, while underlying stocks continue to trade widely, leading to short term dispersion spikes.

I’m pretty pessimistic about things right, now but Cem’s got me beat in his “lost decade” prediction. I don’t think he’s right, but not for any structural reasons, I just think US equities writ large are way to big to fail now.

(If you want way more on this structural flows thesis, here’s a great interview he did with RealVision last week.)

Rob Arnott, Research Affiliates

“If money moves from non-indexed portfolios to indexed portfolios, much of the money doesn’t move, because the index owns most of the market. The non-members in the index get sold, and the members in the index get bought. Every 100 dollars that goes into an index fund, about $80 stays more or less where it is, and about 20% of the portfolio moves from non-members to members. Membership has its privileges. Your worth more if your a member. This anti-value cycle from 2007-2020, was undoubtedly augmented by the flow of money into index funds, and augmented in a big way.”

Rob’s key observation here is that index membership — which is absolutely not a traditional fundamental factor — has very real impacts on stock prices. And if that is so, then it’s ridiculous to say that the presence of the index doesn’t matter at all.

Rob’s new fund, NIXT, owns stocks booted out of indexes. It’s cool, and the math works.

The question is whether or not the average investor can hold it through a revaluation cycle long enough for it to matter. It’s essentially the David Einhorn claim: you can find value, but finding the end-buyer may be more challenging. I’m definitely rooting for him.

I should also add I make the comment in here that the “IPO NYSE and then move to NASDAQ when you know you can get into the Nasdaq-100 was shockingly prescient. Hat tip to Mike Green for screenshotting this “saying the quiet part out loud” from Palantir Board Member Alex More on announcing the move of PLTR to NASDAQ…

Remind me again about how “passive has no effect?”

Cliff Asness, AQR

“It is unlikely to me that all the craziness that I admit happens at 100% passive happens magically at 99.999%. Most things in life are some continuum. So the idea that we’re much more passive now than we used to be, and that’s contributed to some smaller tether to reality? I find that fairly intuitive.”

I think Cliff is mostly right on all his points. I’d summarize his take as “sure, there’s an impact, but it’s not necessarily bad… it’s just different.”

The rise of passive does not mean that number goes down, and you should hedge yourself dramatically. It means the how of markets and valuation are just different, and worth exploring and continuing to pay a lot more attention to. The markets of today are just fundamentally different than the markets of even 5 years ago, much less 30.

And Thus?

So what do you do? Make sure your not relying on 30 year old ideas for how markets respond to flow, information and disruption.

I think Matt Zeigler summarized it best:

Oscar the Grouch on the topic of rain: When it rains, it rains trash out of heaven. Every lucky cloud contains trash out of heaven. We gotta take this whole other take and look for the complete other angle. What if somebody thinks this crap is positive? If we don’t take that complete contrarian view and try to argue it, we have no hope for explaining what is going on here. And they all agree something weird is going on.

I have no horse in this race. Nobody’s paying for me to take a position (or anything else). I have no ulterior motive.

I’m only interested in understanding what’s going on, whether that’s in an F1 race, my relationships, or the markets. And if I’m not constantly trying to figure out what I don’t know, or where my models might be wrong, what’s even the point of being awake?