Tales From the Passive Investor Loop
- 082825
- 3 minutes
It has long been understood that diversification is key for investors. The data show that, after accounting for the fees associated with active investing, it's decidedly anomalous for an actively managed portfolio to outperform the market. Eugene Fama’s work in 1970 concerning the efficient-market hypothesis catalyzed a move toward passive investing. Over the last few decades, passive investing has experienced significant growth in popularity, now accounting for more than half of fund assets.
It’s not for nothing that passive investing has exploded in popularity. Individual investors benefit from lower fees and ready-made diversification options, such as indexes and exchange-traded funds. A passive investment strategy seeks to benefit from the market’s overall performance, rather than trying to preempt idiosyncratic movements, which, in theory, exposes an investor to less risk and volatility.
But the theory behind passive investing is based on a market dominated by active investors. Generally speaking, it’s active investors that keep stock prices in line with expectations for the respective company’s growth. When we see a market “correction” because of a not-so-stellar earnings report or a new product flop, active investors are primarily responsible. When these players make up much of the pool of market investors, we can reasonably expect stock prices to behave in a certain way, which passive investors can take advantage of.
Do the same principles hold when passive investing becomes the norm? We’re currently watching the answer unfold in real time. Since overtaking active funds in 2023, passive funds have continued to grow their share of the US equity market and are expected to continue in this trend. Economists are noticing some interesting behaviors emerging.
For one, passive investments tend to overweight large-cap stocks, in direct contrast to active investors. Since passive investors allocate funds based on a company’s existing market capitalization, the biggest stocks get the lion’s share of passive investments, which further increases these companies’ market cap, leading to more passive investments—and round and round we go.
This may account for at least part of why the “Magnificent 7” have had such an incredible run over the last ten years. It’s debatable whether these top tech stocks are currently overvalued. What can be said for certain is that the S&P 500 clocked its cyclically-adjusted price-to-earnings (CAPE) ratio at 37.8 at the end of July, higher than 95% of historical values since recording began in 1957. This ratio can be an indication of overvaluation; for comparison, 44.2 is the all-time high, recorded in December 1999 heading into the dot-com bubble burst.
A potential danger of this ratcheting system for the valuations of the largest firms could have the most significant impact on passive investors themselves. As passive investing continues to grow and large-cap stocks expand accordingly, passive portfolios will become increasingly concentrated. What began as diverse holdings will eventually become overweighted by a handful of the largest firms, exposing these investors to risk if one or more of these companies faces a downturn.
Some research also shows that the influx of passive investments into large companies’ stocks creates additional idiosyncratic (i.e., firm-specific) volatility. While active investors would typically effect a market correction when large-cap stocks increase too much in price, this volatility discourages such a correction. Without that counterweight, price distortions caused by passive investments persist.
Does all this mean that passive investing should be abandoned? Not necessarily. Many of the issues that are coming to light with passive investing may be mitigated or solved with a hybrid approach. While an exclusively set-and-forget approach has been shown to carry risks to both the investor and the overall market, passive investing under the watchful eye of a finance professional could work well. Regular portfolio rebalancing can help avoid falling into a large-cap feedback loop, keeping both investors and the market in balance.
The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Beacon Advisory or Lincoln Investment. The material presented is provided for informational purposes only. When you link to any of these websites provided here, you are leaving this site. We make no representation as to the completeness or accuracy of information provided at these sites. Nor are we liable for any direct or indirect technical or system issues or consequences arising out of your access to or use of these third-party sites. When you access one of these sites, you assume total responsibility for your use of the sites you are visiting.
Diversification does not guarantee a profit or protect against a loss.
The S&P 500 index is an index of 500 of the largest exchange-traded stocks in the US from a broad range of industries whose collective performance mirrors the overall stock market. It is not possible to invest directly in an index. Past performance is no guarantee of future results.
