February 6, 2020

The Unintended Consequences of the Rise of Index Investing

For the first time in history, the total assets in passive investment vehicles such as index mutual funds and exchange-traded funds (ETFs) surpassed the total amount of assets in actively managed investment funds. In September 2019, assets in passive investment vehicles grew to $4.4 trillion, outpacing the $4.3 trillion in actively managed strategies. This trend is amazing considering that in 2009, only ten years ago, assets in passive strategies totaled only $0.7 trillion (Morningstar). With the momentum in passive investing accelerating, what are the long-term unintended consequences for the market?

Why the rise in passive investing?

Today’s passive investment products are quite different than the traditional broad-based market indexes such as the S&P 500 Index, a collection of the top 500 U.S. companies weighted by market value. Now they include custom index methodologies that are based on sector exposures and certain market factors such as low volatility, momentum, or high dividends. A significant driver of growth in passive investments has been in ETFs, which have responded to investor demands for new ways to get different types of low-cost market exposure.

The rise of passive investment funds makes sense given the market dynamics of the last ten years since the global financial crisis. Unprecedented central bank stimulus and low interest rates fueled a liquidity-driven equity bull market characterized by low market volatility and market momentum, exactly the type of environment that favors low-cost broad market exposure such as can be achieved with index funds. While we believe that index products, such as the S&P 500, can play a role in long-term portfolio construction, we caution against blindly investing in index funds based on past performance, even in this type of market.  It’s important to understand that passive investing is an active choice. A significant risk of passive investing that investors may not be paying attention to is that passive investors tend to own greater and greater proportions of winning companies as the index purchases more of growing stocks. Though these companies have performed well in an up market, their steep rise in value can be the precursor to significant declines in periods of market downturns and increased volatility. Passive managers are unable to take precautionary measures or rebalance to limit risk.

Risks of a market dominated by passive investing

One of the largest risks of the shift to passive investing is that we may be removing critical functions of price discovery in markets as index composition and related fund flows drive equity price performance rather than company fundamentals. It is also blurring the line between investment styles; different indexes have different criteria and methodologies for categorizing stocks, which sometimes allows one company to fit within several types of indexes. For example, in 2019, Apple was included as the second largest holding in the S&P 500 Value Index while also being the top holding in the Russell 1000 Growth Index. Despite negative 2% year-over-year earnings growth, the stock was up over 86% in 2019 and its price to earnings ratio increased from 13.0 at the end of 2018 to 24.8 at the end of 2019 (see table). Fundamentals didn’t drive the stock price higher; we believe the price appreciation was a result of the stock being included in multiple indexes with significant passive inflows.

What is more astonishing is that the explosive growth of passive investment vehicles over the last seven years has created a world that now has more indexes than publicly available stocks (Bloomberg). This dynamic, in which increasing financial sums are tied to a shrinking basket of stocks, can create unintended risks and consequences for investors who naively implement their portfolios with passive funds. Listed here are some potential implications of a rising passive market investors should be aware of.

What can investors do in the face of the indexing trend?

Index funds can have a place in an investment portfolio, but investors should be making an active decision about how to thoughtfully incorporate passive investments into their larger strategy. Understanding both the benefits and risks of passive investments is critical. We work with investors to help determine where the tradeoffs of a passive fund will best serve the portfolio in the long term, and where active managers can be better positioned to mitigate risk and provide return potential across full market cycles.