Weekend reading: Alas, Smith and moans
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Absolutely, I find Terry’s letter muddled. He seems to lament the drivers of what he calls a bubble over several pages before announcing he is at least to some degree now chasing the momentum.
Reads to me like the hubris of a man who cannot simply say we got it completely wrong sitting in unwieldy global consumer goods companies that were struggling against inflation, rising trade barriers and changing consumer preferences and opting out of the companies on the receiving end of trillions of dollars of AI investment.
It’s incredible how sticky assets can be, he has substantially underperformed with remarkable consistency for 5 straight years and yet retains an 11 figure AuM, how is paying 1% and hoping for a change of fortune preferable to the alternatives, I don’t get it.
On a random aside I find myself on holiday at the same hotel as Neil Woodford! perhaps I should ask his perspective…
A very fair summary of the Inelastic Market Hypothesis (conjecture?) Thank you.
It’s not that the (currently positive) net passive inflow explains all of current prices, anymore than information diffusion under the EMH means that all prices always are perfectly optimal and rational.
Rather non price sensitive inflows tend, over time, to increase each of overall market cap, the ratio of investment / disinvestment flow to price changes, the concentration in the largest names (due to index optimisation) and to increased volatility (due to reduced liquidity in the largest companies as market makers don’t increase stock holdings in them at the same rates as their cap weights rise, given the ever increasing compression in spreads for the largest stocks, and therefore reduced profitability per unit of market cap for market makers to the make the market in them).
NB: very recent falls in mega cap hyperscalers could be interpreted as either confirmative or disconfirmative of the IMH. The disconfirmative position is as outlined in the piece (although the IMH does not preclude non passive / active flows from setting day to day pricing, so it’s something of a straw man). The confirmative position for the IMH is that reducing liquidity (per unit of market cap) and increasing volatility in the largest names (due to passive flow effects) means that they will fall (or rise) more quickly, and go to extremes of over sold (or over brought), more frequently and intensely, than otherwise; and that’s exactly what we’ve just seen taken place, as predicted.
“But [Terry Smith’s] sermons were certainly more Puritan than The Church of England.”
That’s not very difficult, given that the Puritans found the Church of England far too close to the “corruption” of Rome, and mystical tradition.
The whole “Mayflower” episode was about escaping to a new territory in the early 1600s, to be able to establish a Puritan colony. The religious tension in England continued until coming to a head in the English Civil War, and the associated Wars of the Three Kingdoms (England, Scotland and Ireland).
Casual, modern interpretations of the English Civil War and the ensuing Republic (Commonwealth) often emphasise the Crown-versus-Parliament aspect, because that makes sense to the secular mind. However, a large portion of the motivation was the ongoing ferment of competing religious ideas, from Roman Catholicism though to ultra-protestant sects which Cromwell himself found intolerable.
Within the Christian domain, the Church of England tends to be pretty broad, from Anglo-Catholics who shock Romans with their preference for the Latin rite, through to fundamentalists who go beyond what, for example, mainstream Methodists consider proper.
Thanks for the Fleetwood Mac subs, maybe they should include “Oh Well” from the Peter Green days.
The Grim Historian piece is an interesting, if long, read.
It isn’t that index funds are intrinsically bad. Index funds are good. Yes, they are cheaper than active funds but, more importantly, they are much more diversified than typical active funds. Given that 80%+ of single stock equities return less than cash, equity portfolio investment is essentially about not missing the big winners. Owning index funds helps you not miss out on that small percentage of stocks that generate nearly all the actual returns from a market.
The issue with index funds is essentially one of their dominance. It should be obvious that if total weight of all index funds asymptotically tends toward 100% of the market cap, then the market would cease to function. It wouldn’t be a market, it wouldn’t be efficient etc. The issue for me is that we are functionally much closer to that that we appreciate. Index funds may not even be 50% of the market, but when we add in active funds that shadow the index, add in those traders trying to front-run index funds etc, the effective impact of index tracking is huge.
The impact on liquidity is the most obvious issue. Essentially, I feel that index-tracking is generating systemic risks. The simple size of the tracker components of Blackrock, Vanguard, State Street, JPMIM is just too big for the rest of the market to clear.
On an different subject, the link “Why nobody understands the AI boom – Groundbrkr” is pretty much where I am on the AI “bubble”. As someone who runs a “long convexity” portfolio, I’m sort of obsessed with the second derivative. I keep seeing things in the current AI boom that keep reminding me of signals before fixed income crises.
I have a couple of explicit momentum ETFs. Jack Bogle really wouldn’t approve of those at all. I sort of follow Terry Smith’s argument and ZXSpectrum48k adds colour “index-tracking is generating systemic risks”
I was tickled by the post that kicked off the end of the professional writer
I use neither, though I have trialled them. In the case of AI writing you lose your voice. And in the case of Google maps you don’t know where the hell you are. I can still use London buses because I learned the high level layout of the city in my student days, well several decades ago. The bus routes are different now, but knowing where they are headed and that old map of the territory is good enough, plus you get to see the city unlike the troglodytes of the Tube. I do appreciate that a retiree is going off-peak and has time, the Tube wins hands down on speed 😉
Asimov’s The Feeling Of Power is salutary. By all means use these tools to explore the problem space, but once you have a solution, make it your own. Waze showed me a great route from Suffolk to Somerset. But I took the time out to identify why it was better than what I had used before. And to get the key switchpoints so that I can drive it unassisted. Because: Asimov knew.
There’s a commonality in the AI writing and the indexing thing. You’re coasting in neutral, and there appears to be a downside of that.
“Coasting in neutral”-what a great phrase however…..
“Investment Coasting” does take a lot of self discipline-the human urge to continually tinker with their investments is all encompassing
However many “amateur “ investors seem to able to manage “Investment Coasting” with outstanding end results outperforming well over 80+% of “active “ investors-that’s a winning investment plan for them-so far
xxd09
I imagine the market being like a polkadot balloon, index funds may inflate the balloon but wont change the relative spacing of the dots. They proportionately scale up the effect of what traders do, rather than resist it. If index funds were sold, it’d take air out the entire balloon, but the relative price differences between different companies wouldn’t change. Likewise an overly large proportion of money in index funds wouldn’t create real trading opportunities because the relative price of everything moves in proportion
Smith, etc, justifying job. There’ll always be active people for various reasons
@Matthew Ainsworth #9: it’s a rather beautiful and very clear analogy which you use (it reminds me somewhat of the ‘smooth tension’ features of the cosmological constant model of ‘dark energy’, or of Roger Penrose’s ideas about Cyclic Conformal scaling Cosmology).
And I agree with you that Terry Smith is just talking his own book.
I also think that he makes a rather poorly argued case in his letter against passive indexation (and is not convincing to me in explaining, less still in justifying, his underperformance, especially given Fundsmiths’ hefty near 1% p.a. fee (compared to the just 0.25% to 0.45% p.a. charged for the UCITS Quality Factor ETFs on offer in the UK).
But, I have to respectfully disagree fundamentally with your logic elsewhere, which reflects a consensus about passive share which, IMHO, is both flawed at the level of first principles, and perhaps already empirically falsified.
Passive flows aren’t neutral scalers.
Cap weighting creates actual differential impact upon relative prices.
Index funds buy in proportion to current market cap.
When inflows arrive, they disproportionately purchase the largest constituents (e.g., Apple, NVIDIA, Microsoft) because those already dominate the weights.
Smaller stocks therefore must and do receive far less absolute buying pressure.
Moreover, most capital in index tracking ETFs and funds uses some form of optimised methodology, rather than buying every stock in the index at cap weight.
Large stocks are the least elastic (they are the hardest to substitute for in the index), which means that the index tracker ETF or fund using optimisation must buy them at whatever price.
And so in/out flows push their prices up/down even more again than for their smaller peers.
Accordingly, a dollar or pound going into passive funds doesn’t just “inflate the balloon uniformly.”
Rather. it creates outsized, persistent upward pressure, especially and specifically upon relatively inelastic mega caps.
Empirical work (Gabaix/Koijen, Michael Green’s analysis with others) uses granular instrumental variables to trace this. Flows drive prices more than fundamentals in inelastic regimes (e.g., $5–$8+ of market cap increase / decrease per $1 inflow /outflow arises, as compared with passive advocates’ assumption of next to no impact, and the observed effects being even higher for the largest stocks, and rising over time as passive share grows).
Your analogy assumes active traders (“what traders do”) can maintain relative spacings.
But, as passive share grows, so the free “float” available for active trading shrinks, especially in mega caps. In this regard, it’s the ratio between the active share and the passive share that matters here.
This leaves active managers facing a thinner, more inelastic market where, in effect, more than half (and rising) of the owners (passive) won’t sell at reasonable prices
@Delta hedge – maybe blowing up a surgical glove is a more accurate analogy! – some parts of the “balloon” are in different ratio to each other – some parts more elastic than others in preknown ways decided by traders, the nominal pound amount is growing more where the market cap is already more (the fingers of the glove can stretch more), but I think it’s maintaining some sort of predictable proportionality – the same overall shape as such. If percentages drift maybe something is squared somewhere, but ultimately that predictability makes it hard for anything it does to not already be priced in, which is why I think increasing indexing doesn’t create much opportunity by itself as it doesn’t increase the unknown – you know one finger of the glove isn’t going to suddenly get 3x longer than another finger when the glove as a whole is inflating
A thinner market for traders should mean that when they collectively buy or sell, price moves more because they are operating from a smaller pool, they have to bid higher to actually buy or lower to actually sell, as the index fund is like an unresponsive obstacle – almost a like large stone inside the balloon, maybe like how all the lost bitcoins that’ll never be sold mean people trading that operate in what’s a smaller real market
@ZX – I’d appreciate your take on this, but the market cap framing for passive funds has always struck me as the wrong metric. What we should be looking at if we’re concerned about that is how much of the daily trading volume is index funds vs. active market participants, as price discovery happens at the margins.
The natural extension of this is the inelastic markets hypothesis, but this should theoretically create arbitrage opportunities for anyone paying attention with the capital to act on them, so either the arbitrage is real and it gets traded away, or there’s a specific reason why it can’t be (not enough risk capital, no way to know the ‘correct’ price etc.).
[As an aside, re Smith – it always frustrates me that people never properly benchmark him. He’s a quality growth manager, so judging his performance fairly means comparing him to something like the MSCI World Quality factor, not the MSCI World – otherwise he just gets credit for a period where quality happened to be doing really well.]
@xxd09, SkinnyJames: returns, volatility, liquidity all come in streaks.
Regimes come and go.
Managers and styles like Woodford’s and Smith’s come in and out of fashion.
There are cycles.
Things rhyme, then reverse.
A benchmark like the MSCI World or World Quality Factor indices can’t fully capture these regime changes.
They only compare like to like (equity v equity, quality v quality). What about like to dislike?
A truly successful strategy is one which can survive across many regimes with a high likelihood of high CAGR, low max drawdown and low drawdown duration, with higher reward per unit of risk etc.
Show me a mainstream fund manager or passive ETF which had done that over generational timescales, and where it was consistently and reliably identified in advance (using an easily repeatable framework) who they were and which funds they were.
Growth and tech are having a long day in the sun.
Since it’s inception on 11th February 2010 the 3x NASDAQ LETF TQQQ has returned 37,360% (374.6x) cumulative nominal, 24,021% (240x) real terms cumulative and 43.5% CAGR net nominal.
Just from dumb and they come buy and hold.
But, had it (TQQQ) existed on the same terms as now (but with the prevailing funding costs then for the leverage) then from April 2000 to March 2009 a (synthetic simulated) TQQQ would have fallen by 99.98% cumulative, turning $100,000 into just 20 bucks.
It’s like that film “Trading Places”. It all depends which side of the tracks you find yourself on.
With B&H ‘passive’ approaches time it right (even once in generation sometimes) you can do very well. Time it wrong you can eviscerate yourself.
@ermine #7: “explicit momentum ETFs”. Building in a simple to operate ten months’ (two hundred trading days’) Simple Moving Average on/off filter rule to a index tracking momentum ETF (SPMO for top decile momentum within the index) does wonders.
It (as such a simple unlevered system) virtually matched the performance of selecting the single overall
best total performing of all the 29,078 US single stocks listed over the whole period from December 1925 to December 2023 (Philip Morris/ Altria, which would have turned $100 into $265 million for a 16.3% CAGR): see my comment as HBCTIA (Howard Beale Can’t Take It Anymore, “Network”, 1976) to the Reddit post here:
https://www.reddit.com/r/LETFs/s/4om8dvzXxj
@Delta Hedge – I’d argue that proper benchmarking does capture regime change (so long as the manger’s style doesn’t change), if quality is out of fasion and Smith is doing as badly as the MSCI Quality Factor benchmark, then that’s justifiable. The point on proper benchmarking is to be able to seperate the factor’s beta with the manager’s alpha (or lack of it).
@DH #13 > (two hundred trading days’) Simple Moving Average on/off filter rule to a index tracking momentum ETF
Thanks for that. I moved into momentum (and value momentum) because of the same reasons all the passivistas on here seem to be leaping off the wagon.
But with generic momentum there is the philosophical problem of when/how do you get out of momentum, it’s not entirely B&H The second fund is exceptionally evil in that it shifts into other asset classes, I will be interested to see how that works in the AI crash yet to come. But for the more generic value momentum, that SMA could be informative.
Actually, I was thinking that maybe there won’t be an ‘AI Crash’, and that perhaps there will be a steady deflation.
Big companies come, big companies go.., bust ( Northern Telecom ), taken over, crippled by lawsuits ( Minolta ), merge ( Konica Minolta ), sold off ( Konica Minolta camera division to Sony ), get out of retail, and go for the easier life of B2B, or government contracts ( IBM, Fujitsu, Blackberry ( RIM as was ). And all the rest.
So, with AI, the littler (!) players give up, scale back into some niche, get absorbed for their customer base/some successful part of their business/take your pick. And the mightier ones, and everyone else, stops talking about AI as it becomes part of the infrastructure of business. Or…, who knows ?
As for index investing, I think I’ll just keep on in that direction. Active investing mostly feels to me like just another worry. And the nearest I’ve got to following ‘star’ investors is my less than a handful of BERKS (B).
Delta Hedge-agree returns,volatility,liquidity (risk?) are what it’s all about for the investor
Unfortunately there is no sure way(investment policy) of handling these tremendous variables by the amateur investor so “buy and hold” ie index investing has turned out to be one reasonably successful way of dealing with with these conundrums
Investors should then concentrate their efforts on matters under their direct control ie saving as much as they can,living frugally and watching costs
Mr Market seems to do best when left alone!
xxd09
#16:@Trufflehunt: The US March/April 2000 to September/October 2002 (UK Dec 1999 – March 2003) tech crash saw remarkably few real economy effects. GDP growth slowed substantially, but it still grew in a muted fashion.
And this was against a backdrop of a 78% fall in the broader index (Nasdaq) and an 82% crash in the associated (unlevered) tracker ETF (QQQ) (if you were levered 2x or 3x then you would have taken a virtual wipeout).
So your thesis is plausible.
But, notwithstanding that slightly reassuring near term historical precedent of sorts, this one does look worryingly big.
Data centre Capex is now such a high proportion of US GDP growth.
Maybe any crash stays in the stock market, but, like Ed Zitron is, I’d be quite worried where this all ends up eventually for the average Joe in the street.
Quite possibly not well, like it didn’t after 2008, even if Mr and Mrs ‘Joe ordinary’ never puts so much as a single penny down direct into either semiconductor or memory stocks, or even into the hyperscalers themselves:
https://youtu.be/3u0KeTC7jso?si=icNRADEUHe8LhMJh
Still, I think Ed’s maybe a tad too harsh on whether there’s actually a product here.
This isn’t, I think, another case of the Crypto Bros’ ’empty boxes’, as SBF revealing confessed to just before FTX imploded, and he went to jail.
There is something here.
On the one hand, it’s clearly not either ASI nor even AGI, and I don’t think it can even properly be called AI yet, because its intelligent sounding, sometimes (remarkably) accurate (sometimes shockingly not) output comes from a non conscious/non self aware process.
Moreover, on that score, even if the deal breaker on the “I” in AI is not the issue of the foundational probabilistic nature of LLMs, versus the received template (pre 2017 or so) that ‘real’ AI would be deterministic (symbolic language based, i.e. programmed); then there’s still the bigger, practical (emergent, functional) issue that (whilst LLMs can be an incredible and useful ML tool, albeit one uneven in so, so many ways) they’ll never ever behave like we expected AI to (* see below on why).
However, on the other hand, they (LLMs) are something.
On a good day at work (a focussed, productive one) using Enterprise level GPT 5.5 Thinking I can in ~8 hours output what would realistically take me at least 24 hours of solid, non stop work in pre LLM world. It’s just a fact.
I see it with my own eyes (and I’m not hallucinating the productivity gain, like the LLM might a confidently misstate a fact, although it does this ever less so in my experience).
Sure, it requires enormous levels of human professional end user intervention and interaction, but it (ML) is capable, in many tasks, and when used correctly, of either massively speeding up the task, doing the task to a level of thoroughness time would not otherwise permit, or of getting through far more tasks in the same time.
So, whilst I do find Ed very persuasive (and easy to listen to, and to read on his blog); I am still thinking that, for all of the collosal issues and problems with the LLM economic ‘ecosystem’ (circular financing, a massively loss making business model, no way to fund or build so many data centres, or to provide the power on time or at all etc etc) that, eventually, there’s still got to be an eventual demand out there from the end user consumer facing businesses equivalent to a multi hundreds of billions to some trillions of dollars of annual revenues, even if we don’t get beyond the current LLM type of ML, and there’s no agentic AI revolution which sees mass replacement of people with ‘thinking machines’ (although, Small Language Models, running with specialised chips on device/on phone might upend all that entirely).
Which is all a very long way of saying that a crash might or might not tip us into an abyss; and, as you say, there’s also either a slow grind sideways or a gradual deflation of expectations set of scenarios (although, I seem to remember people saying much the same things about Dot.com in the later nineteen nineties – certainly everyone back then expected the crash, which didn’t make it any easier for those invested then when it came, and was, at it turned out to be so very steep; to win you have first to survive, after all).
(* see here today for why:
https://youtu.be/yRZC6KfcO88?si=sCPqzDeYybPIMiUQ )
Interesting discussion, as always. Smith makes half-baked arguments, hope he is more rigorous with his stock selection. Others here (@DH, @ZXSpectrum) have made a more convincing case. Though I keep coming back to the point: Passive flows are predictable (fact). If they change prices, then active investors should be able to profit, and arbitrage the distortion away. If this is not happening, why not? Maybe the spoils go to certain hedge funds, not traditional buy-and-hold managers.
@Sparschwein #20: The very short answer is that there are real limits to arbitrage.
Passive inflows can induce prices to drift away from fundamentals if they make informed active investing relatively less effective.
The binding constraint is essentially whether someone can safely and cheaply trade against the over or under valuation.
Mispricing can persist and worsen when arbitrage is costly and/or risky; as is especially the case with, say, shorting a rising (high momentum) stock.
There’s a lot of academic work on this in relation to (Fama-French) factors (value, size, liquidity, profitability/quality, low volatility) and in relation to momentum (which isn’t, IMHO, as such, a factor per se but, instead, I think more like an abiding and underlying feature of market structure itself; i.e. sometimes value stocks have high/low momentum, sometimes growth stocks; and sometimes it’s large caps, and sometimes small).
That work is possibly relevant here because the effects of (and also perhaps, to an extent, the mechanisms of) passive flow effects are somewhat similar to momentum effects.
This paper (“The Limits of the Limits of Arbitrage”) from 2009 is a must (if only for the title):
https://www.bartlit-beck.com/assets/htmldocuments/limits%20of%20the%20limits.pdf
The paper predates the passive flow debate by a while, but is, I think, still relevant to it because it does conclude that the survival of overvaluation depends upon broader frictions like idiosyncratic risk and shorting/implementation costs, and that these are real, substantial and common.
Those types of risk are present (indeed acute) in an active arbitrageur trying to trade against the direction of passive (indeed any) capital flow.
Looking at all the empirical evidence, the authors of the paper find that, for overvaluation anomalies (such as passive flow is being put in the frame for now), the limits to arbitrage model works fairly well (but, oddly perhaps, it doesn’t explain convincingly undervaluation).
@DH – thanks for the link. It’s interesting, though frankly I can’t do it justice in terms of properly reading a scientific paper (critique the methods; do the results support the conclusions; put results in the context of the body of research in the field, etc).
No doubt that there are limits to arbitrage, in general, and markets sometimes remain irrational for periods of time. The authors in that paper frame their research as into the “survival of *irrationality-induced* financial anomalies”.
I think that index fund flows are rather rational, mechanistic and predictable.
I asked GPT5.6 to define the academic research consensus, because it’s not my area of expertise, and I have learned to be skeptical of narratives that serve big financial interests (also see smoking or climate change denial as examples of such influencing campaigns)
*AI slop below*
Do index-related flows move prices independently of fundamentals?
Yes, at the margin. Index additions, deletions, rebalancing and ETF arbitrage create identifiable price pressure, especially over short horizons and in smaller or less liquid stocks.
Do index funds impair price discovery across developed equity markets?
Possibly to a modest degree, but the net effect remains contested. They reduce some firm-specific information production and increase common price movements, but other mechanisms improve or preserve informational efficiency.
Is the stock market already fundamentally broken by passive investing?
No. This is a niche position, not the research consensus.
Yes. Enterprise Copilot GPT 5.6 Thinking dropped at work today. 1st impressions are just an incremental improvement, but noticeable.
Maybe not much, but we seem to edge up by 0.1 on the MSTF/OAI model sequence every month now (more or less); so, even if it’s small steps, it’s many and rapid small steps.
But… it’s the old ‘only a mirror to the consensus’ problem (where the consensus here is, in some sense and within some limit, just a lowest common denominator, so like Weizenbaum’s ELIZA redux).
Your quoted GPT 5.6 output reflects only such a sum over consensus view because, given that view (as embedded within the model’s training data set and its search capability), that’s where the steepest gradient descent is found in the LLM’s internal ‘landscape’ of entropy loss reduction.
Sum over consensus doesn’t necessarily make for truth, even with inference. So, I have to respectfully disagree with GPT 5.6 on this.
I wouldn’t call it slop though. I think that’s a lazy term. It *might* be useful output. It might not. It could also be something different or inbetween.
In any event, you have to exercise a judgment over the outputs.
The LLM might be a genius in a data centre, but it doesn’t have a realistic model of the world which, definitionally, can only come fully from being an embodied entity with a real stake (e.g. survival) within the physical world.
Here the real world consequences of the sum over consensus being wrong are that the market eventually blows up, and you/we all suffer hardship as a result.
The LLM doesn’t have a stake in that, or an understanding of what that risk means to a real person.
It can predict precisely the most likely shape of the next token, but can’t even approximately experience what it would feel like for Terry Smith and Mike Green to be right here, and for the market (e.g. principally the Nasdaq 100) to, say. first triple on passive flow exacerbated (with narrative tailwind) AI hype only to then crash 80% or 85% (as happened from 1929 to 1932).
Given Smith’s reliance on Simon Evan-Cook, I thought that it might be helpful to link to the actual article by SE-C:
https://open.substack.com/pub/simonevancook/p/victory-for-passive-22-thoughts-and
@DH @Sparschwein — Just on Monevator posting etiquette, whether one calls it AI slop or ‘AI output’ or something else, I appreciated the shift to AI generated text being flagged as such in the comment.
A very good habit for us all to get into, especially on Monevator (and as perhaps @Sparschwein recalls, necessary here where I am trying to be alert to AI text in comments and will delete if not so labelled at the least…) Cheers!
Well, how can we know anything about complicated technical matters, short of doing a PhD thesis on the subject?
If there is a genuine debate among the experts, I want to know. (GPT5.5 and 5.6 are quite thorough, good enough to detect this.) A broad consensus among the researchers it is of course not The Truth; it’s just the best available approximation at this time. And the few niche voices that claim the opposite may be fascinating, but are more likely wrong than right.
Another principle: Extraordinary claims – extraordinary evidence. The consensus (as summarised by GPT) is balanced and makes no extraordinary claims.
As for Cook’s piece, that’s the kind of fact-free rhetoric that has written “charlatan” or “lobbyist” all over. Assume that passive is driving anything and everything in the markets (with zero data or argument), then list everything wrong with the markets today, and voila: passive is BAD. QED.
Although ‘extraordinary claims require extraordinary evidence’ is not a prerequisite in most theories of knowledge (and would have presented real issues for each of heliocentrism, relativity, atomic theory and quantum mechanics, for examples, long after they became regarded as scientific, and, therefore, necessarily, provisional ‘truths’), not least because who and how exactly defines “extraordinary”: Is it an extraordinary claim being made here (under the Inelastic Markets Hypothesis)?
It’s Economics 101 that the marginal buyer and seller determine price. Demand/supply curves (and volume analysis) is integral to trading, including in equities. It’s irrefutable that net passive flow is a source of buying and selling, and it is definitionally true that it is price insensitive (e.g. new contributions have to be invested immediately at market cap weightings).
The extraordinary claim (for which extraordinary evidence might be needed, by parity of reasoning) is that passive flows don’t affect market prices.
That’s the unproven claim (and perhaps the leap of faith which so called passive investment requires).
You certainly can’t judge the validity of a claim because of its popularity or unpopularity. On that logic we’d still be burning witches and what not. It’s an appeal to an asserted authority, not to evidence and to reason.
Spread is the price for immediacy. The as yet unproven (and possibly weakly or not supported) assumption being made seems to be that the market will always clear at reasonable prices; and that at the scale of the market and it’s largest market cap share participants, liquidity will always be there. But even before passive share began (recently) to dominate that’s been questionable given, for instance, the 2010 Flash Crash and the October 1987 Crash.
@Delta Hedge — Well personally I think it is an extraordinary claim that passive fund flows are meaningfully distorting prices over the long-term, let alone — as some of the critics suggest — pumping up the market to unsustainably high levels (versus all the usual forces that have been pumping up the market and taking it back down since time immemorial 🙂 )
In fact this thesis is still very much non-consensus.
You mention supply and demand. Remember most of the bulk of what is in index fund is not traded as the market moves up and down. It is only new $ flows in/out that require new buying. I’m quite happy to believe that after 30 years the market has largely arbitraged away most of the inefficiencies here, at least on an average day. And I don’t think index funds are ‘breaking the market’ by the cumulative impact of non-average days (e.g. the crash days you cite).
Index Funds under Management are now huge but they represent a very small amount of share trading. FWIW Vanguard has estimated 1% of daily volumne (https://corporate.vanguard.com/content/dam/corp/research/pdf/setting_the_record_straight_the_truths_about_index_fund_investing.pdf)
To me it seems like forcing the issue to believe that 1% trading volume is the smoking gun that has killed market efficiency or whatever is being claimed. Especially, as has been countered many times, that there are plenty on the other side who would seek to profit from any inefficiencies introduced (/arbitrage them away).
If one wanted to look for novel non-rational factors setting pricing, then (say) the advent of free stock dealing or the withdrawal of more staid institutions from certain areas of market making seem at least as credible. But as I allude to above, I don’t actually think we need to look for anything new. 🙂
I have more sympathy with the other (related) idea that growing passive/index fund share is increasing volatility. As fewer shares are actively traded (because the rest in fact aren’t being traded, as they’re sat in index funds) this would reduce the free float and could well hinder price discovery. This seems far less novel a claim, and in fact it’s very easily seen in shares that are illiquid for all kinds of other reasons. (Small free float, large family ownership, obscure exchange, whatever).
So for my part it’s ‘very possibly’ on higher volatility but ‘strong doubts’ on ‘bidding up and breaking the market’ per Green et al.
For sure the market will crash some day. It will benefit some to say it was all the fault of index/passive investing. So they will say it. But, as I mention in my piece, it is not obvious at all to me that it’s true. Perhaps if I did a bunch of maths I could show otherwise, but there seem to be plenty of smart academics etc who have done the maths and say nada too.
All FWIW, which very well might be very little. 😉
Actually very few academics are willing to look into this.
But amongst those that have the picture is not generally reassuring.
Vanguard’s number reflects only net, cash flow adjusted fund turnover, i.e., trades the fund itself makes after netting out inflows/ outflows, measured against total exchange volume.
But that’s just the tip of the iceberg, since it ignores index rebalancing mechanics, inclusions / deletions, float updates, dividend reinvestment, and the ETF creation / redemption plumbing where authorised participants hedge with cash equities, futures, and swaps activity that shows up as dealer or derivatives flow, not fund turnover.
Trading volume arguably isn’t the right lens here anyway.
Instead it’s how much capital behaves inelastically like an index, not how big index funds are by trade count.
On that basis Green and others estimate passive like behavior, aggregated at the owner level, is well over 50% of market capitalisation.
He’s stated it more bluntly elsewhere.
In one interview he said, perhaps rather harshly, that he thinks Vanguard should be held liable for misleading people with this stat (the 1%), contrasting it with his own estimate that active management’s share of trading volume has fallen from about 80% in 1995 to roughly 6-7% today.
On broader passive share estimates, Green cites academic work (Chinco & Sammon) finding that around 35% of shares trade within a day of index reconstitution events (i.e. passive driven) under the strictest definition, rising to about 45% within a five day window, numbers he uses to argue the commonly cited ~15% passive-share figure (just adding up Vanguard/ BlackRock/State Street ownership) massively understates things too.
None of this was an issue at 15% passive share. At 54% today, it’s becoming one. If we get into the 80% range we’ll surely see things break down (?)
This has never been tried before. There is no reassuring precedent. The precautionary pricinciple would be apt.
It’s also I suspect not coincidence that the CAPE increasingly failed to provide useful info as passive share of assets and turnover role. But that perhaps is another debate for another day.
@DH. I think the idea that Vanguard is only 1% of volumes is an utter nonsense. Trading flows from index funds totally dwarf any other type of investor. If I interrogate our internal AI systems on daily equity flows, they estimate anything between 5% and 25% is now active depending on the specific market. You have trackers themselves, active funds that shadow trackers to a much greater degree, derivative books tracking the index fund flows and trying to front run them.
From my perspective, equities is going the way of bonds. Bonds led equities by a decade (or two) in terms of moving to index type products. Bonds are intrinsically much simpler product than equities. You can synthetically replicate a government bond index with three bonds typically to 95% confidence level using simply duration/convexity matching or PCA. With 4-6 bonds, you can toward 99%+. Add in futures and you don’t even need to use your balance sheet. It makes a mockery of active bond funds who tried to charge 1% or whatever. When yields collapsed after the 2008 crises, that really put the stake into active bond management. You are not paying 1% for someone to manage a bond fund yielding 1%!
As concentration risk increases in the large equity indices due to US tech it’s becoming ever easier to replicate. Why bother buying 500 stocks, when the returns are mostly generated by 7.
I’d also point to the inherent corruption we are now seeing in equity indices. In bonds this was always an issue. Sovereigns or corp issuers wanted their bonds in the index since this reduced the yield they had to pay. I can still remember the pressure I was under 25 years ago to allow certain countries to join specific indices. We are seeing exactly the same now in equity indices. It’s all about using index investors as exit liquidity for private holdings.
I fear we are all the intended exit liquidity in the end! 😉 C’est la vie.
Never before Boglemania took hold (and a good idea, up to then, started to attract an almost religious like following) was there ever such a dominating actor in the market who, algorithmically here, must (almost immediately) buy when receiving inflow cash from investors / retirement plans and must (almost immediately) sell on outflows, with no regard whatsoever to valuation (or any other fundamentals, or for macro prospects, i.e. “Did you give me cash? Buy. Did you ask for cash? Sell”, as Green succinctly puts it).
It’s a simple fact that the largest of the large mega caps, who receive more in/out flow from passive by virtue of their size, most often have significantly lower relative liquidity (as trading volume doesn’t scale linearly with huge market caps) and higher ownership by other passive holders, making supply even more inelastic.
So, I just can’t understand how @TI maintains this won’t meaningfully impact prices, given that institutions and passive funds have constrained mandates (with target fixed equity allocations, benchmark tracking, or fully invested rules), so they don’t/can’t easily sell other assets or adjust much to price changes.
When new cash arrives/departs, passive funds buy/sell proportionally.
Prices have to rise / sell to induce some selling / buying from less constrained holders (active managers, individuals, corporations via buybacks, etc).
So, of course, it has to meaningfully affect price.
Not because the fundamentals have changed, but because the end of the month 401K fund contributions came in, because the passive 60/40 (or whatever) fixed allocation funds had to do their end of month or quarterly rebalance etc.
And large stocks are also stickier in aggregate. Institutional owners don’t sell just because prices rise. So index rules reinforce weights. Active managers offset only partially (~2/3 per some research, like Haddad et al).
So, big stocks rise more. Their index weights increase. The next inflows allocate even more to them. This drives concentration.
Of course the stickiness of institutional ownership is not, as such, and in itself, new.
But the relentless, and increasingly dominating, passive bid is new to the post GFC world, and it pours the fuel onto this.
Lots of it.
An untested risk with tens of trillions of the World’s paper wealth.
What could possibly go wrong?
So I urge the undecided:
Have a look at the academic/empirical work that there is (which we’re very fortunate for, given the reluctance by most to so much as look at this topic).
Have a read of Gabaix’s/Koijen’s papers on index additions (big price jumps, especially for large firms); and flow impact studies showing largest stocks outperform on passive inflow quarters.
Check out Krishnan’s/Sturm’s models where, when passive share passes (a not so far off now) threshold (~65%+), then volatility explodes endogenously.
If the flow to cap change ratio is now somewhere from 5x up to 25x (and Green thinks it’s 17x to 25x for the SPY for passive flows right now), then what’ll happen if the music stops at a (near?) future ratio scraping triple digits?
Each generation is getting that bit smaller than the last now onwards and less able to save and invest than the last one was relative to the ever increasing proportion of the population in, or going into, decumulation.
Some day those passive flows going into equities (especially US Large Caps) will become flows out.
It doesn’t need a recession to happen (although that would be an accelerating and aggravating circumstance).
What’s going to happen then?
A few hundreds of billions of annual net outflows could equate to yearly market cap changes easily topping $10T.
Given the paper wealth to spending relationship, whilst a recession isn’t required to cause fund flow reversal, flow reversal might well cause a recession.
So, I can’t subscribe to the general enthusiasm for the EMH and for rising passive share.
And I’d rather be early than wrong.
@DH — I didn’t say I didn’t believe a greater passive share would not affect prices. Indeed I specifically noted that I can quite believe it increases volatility (i.e. prices).
What I don’t see (with admittedly only a passing interest) is a slam dunk case for passive bid pushing the market up, per some critics, and more specifically one that we should be particularly worried about versus all the usual suspects that we’d expect to be pushing the market up right around now in the cycle.
As for all the rest, it reminds me of the sort of (unrelated) stuff I heard about Strategy when it was issuing shares priced over NAV to buy BTC. It was an infinite money glitch, we were told, with lots of theories tossed about that apparently I had to go off and read and understand for enlightenment.
I saw something much simpler: a roll-up / valuation arbitrage. I was told (here on this blog and on the socials) that I didn’t get it.
Strategy is down c. 80% from its highs and trading at 30% off NAV, so perhaps I did get it. (And, for the record, I own a tiny bit of Strategy again 😉 )
Again, if there were 100 shares in the market of Company Z and 95 of them used to be owned by active participants and now only 50 are (say) then absolutely I can see that it affects price discovery / volatility versus when more shares were actively traded. But in both directions.
In my bear-of-a-simple-brain framework, the biggest reason to believe passive/index investing will cause problems is because historically a good idea taken too far in finance pretty much always does. I’m not constitutionally averse to the dangers.
But, again, I don’t feel the need to look at passive/index funds to explain (much) of what’s going on when I have a likely AI bubble, retail investing degeneracy, a 15-year bull market, bear/short capitulation, a President who name checks the Dow in his rambles, deregulation all over the shop, crowded hedge fund equity positioning – and that list could go on – to finger… 🙂
The MSTR/Strategy comparison cuts both ways, and maybe more the other way.
Saylor creates upward buy pressure on BTC by issuing shares (prima facie dilutive) to buy more BTC (potentially accretive) which, given Strategy was on a premium off of the expectations for more BTC appreciation (per coin in USD, and per MSTR share) can increase both the BTC price (which is fundamentally illiquid, given that upto 96% of BTC buy/sell volume is wash trades, not least by smaller exchanges using their own BTC to give a false impression of liquidity and market depth) and also Strategy’s own share price (as it’s NAV premium and BTC per share rise in lockstep).
And when BTC fell the whole cycle reversed and Strategy crashed over 80% to BTC’s ATH to trough 50% fall.
That’s arguably an analogy of sorts for the IMH here; with the passive flow in and out of equities (especially the US mega caps) substituting for rising MSTR NAV premia as the source of endogenous price insensitive buying.
The difference is that, at least until recently, Strategy was statedly (very) reluctant to sell its BTC, whereas passive flow is quite naturally two way, and, therefore, fundamentally directionally non preferential.
If there’s more accumulators’ aggregate capital investing to retire then the natural direction of flows is inwardly; and if there’s more in aggregate capital terms of decumulators needing pension funds via drawdown / withdrawals, then it’s outward.
So, arguably, there’s more to worry about than with BTC (and MSTR) here as there’s no deep seated HoDLing commitment to hold shares, like there is for Strategy’s Board for BTC. Equities are just the asset class which happens to be in the retiree’s account in order to get sold down to pay for the cost of living without paid work.
I don’t like the label Ponzi (like I don’t with the use of the term ‘passive’) since it tends to obscure more nuances than any truths that its’ use can usefully compress; but, in a sense, the whole of civilisation has been a Ponzi, because you just can’t have infinite growth on a finite planet, and, sooner or later, population and consumption stops increasing.
Likewise for the equity markets.
So too with them, sooner or later, the passive demand for shares has to stop increasing (passive share can’t go above 100%, after all), and, eventually, and in aggregate, they’ll be more passive investors selling out of the market to decumulate than are paying in to accumulate.
Given current valuations, I wouldn’t want to be a bag holder at that point in time.