There’ve been all sorts of indexing scare stories over the years. When the first index fund for retail investors was launched in the mid-1970s, Edward Johnson, who was then chairman of Fidelity, called it “un-American”, on the basis that Americans generally don’t like “settling for average”.
Johnson was, of course, completely missing the point that, net of costs, investors in Fidelity’s funds had in effect been settling for less than the market average for years, but that’s another story.
An even more ridiculous criticism is that index investing is "worse than Marxism" and is somehow undermining capitalism. Elon Musk has weighed in on the issue several times, even likening investment consultants who recommend index funds to ISIS (yup, the jihadist terror group — work that one out!)
Other anti-indexing tropes belong in what we could call the “So what?” pile. I’m regularly reminded by advocates of active management, for example, that passive investing is not entirely passive. They are, of course, quite right; it’s not. But what’s the point they’re trying to make? Passive or not, indexing is a superior strategy to using active funds. As Trillions author Robin Wigglesworth wrote recently, it’s not “as if the vast majority of people that use passive strategies do so only for dogmatic market-efficiency zealotry. They do it because the long-term net results both for individuals and institutions are vastly better.”
Most critics are conflicted
Almost all of these objections have one thing in common: they’re made by people with a vested commercial interest in dissing index funds. (Arguably, Elon Musk is an exception, as index funds have helped to make him the world’s richest man, but perhaps I should tackle that one in a future article).
So when I read that Goldman Sachs had published a report on the effects of the rise in passive ownership, I was fully expecting it to poke more holes in indexing. After all, Goldman has historically made huge profits from active money management, even if most of its customers haven’t.
Surprisingly, however, the Goldman researchers, headed by the company’s chief U.S. equity strategist David Kostin, found that some of the biggest scare stories surrounding the growth in passive assets are totally unfounded.
Here are three myths about indexing in particular that the report dispels.
Myth 1: It causes stock prices to move in lockstep
Passive investing is often blamed for high degrees of correlation between equity prices, particularly in major indices like the S&P 500. In other words, critics say, inflows into passive funds cause all stocks to move in the same proportions.
However, David Kostin and his team found this to be completely untrue. Correlation, they established, has in fact declined over the past ten years — precisely the period when passive investing has been firmly on the ascendant.
“A common investor concern,” the report says, “is that demand from passive investors is not tied to company-specific factors, and as a result would cause stock returns to be less micro-driven. A time series of S&P 500 stock correlation has shown a downward trend over the past decade, and this year fell to a low of 0.08, a similar level to troughs reached in 1995, 2000, 2006, 2007, 2017 and 2018.”
Myth 2: It causes cyclical bubbles
Another argument we hear from critics of passive investing is that it artificially boosts returns of the stocks in major indices, thereby causing cyclical bubbles such as the recent boom in the price of companies, like NVIDIA, involved in artificial intelligence.
This criticism is largely based on a fundamental, and common, misunderstanding of how an index fund actually operates. If a stock goes up in price, the fund doesn’t need to buy more of the stock because it already holds a proportional amount of it.
Again, Goldman Sachs found no evidence at all that passive investing inflates the price of stocks.
“Across the S&P 500,” the report says, “we find after controlling for fundamentals, passive ownership does not help explain any additional variation in valuation multiples… In addition, the importance of passive ownership for stock multiples, aside from not being statistically significant, is weaker than the importance of fundamentals.”
Myth 3: It distorts the returns of certain stocks
A third criticism, closely related to the second, is that the growth of passive investing means that stocks with higher levels of passive ownership generate higher returns than those with lower levels of passive ownership.
But Kostin and his colleagues found little discernible pattern between higher returns and passive ownership. On the contrary, in fact, stocks with the highest passive ownership have generally underperformed over the past decade.
The report says: “Performance since 2000 has been inconsistent. Stocks with higher passive ownership outperformed up until 2014 before plateauing and subsequently giving back of most of the early 2000s gains over the past five years.”
No evidence of negative impacts
The shift from active to passive investing has, without doubt, been colossal. The Goldman paper notes that, cumulatively, $2.8 trillion has flowed into passive US equity mutual funds and ETFs over the past decade. Over the same period, $3 trillion has flowed out of actively managed funds. What’s more, the trend appears to have accelerated over the last five years.
To an extent, the UK and Europe are playing catch-up, so we can expect to see this trend play out on our side of the pond for many more years to come.
But just because we’re seeing a massive shift from active to passive, that doesn’t mean that it’s having a negative impact on the markets, the economy, capitalism, or indeed anything else, with the single exception of fund industry profits. Indeed, the impact on the industry is precisely the reason why indexing scare stories receive so much attention.
There are examples, it’s true, of the rise in passive ownership affecting individual securities. Research into the possibility of broader consequences will continue, and any findings will need to be carefully looked at. But, so far, there is no evidence that passive investing is affecting markets on a macro level.
Goldman Sachs has made its report freely available. You can read it here.
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