Passive investing offers easy access to markets … but at what cost?

Passive investments like ETFs create conditions that are ultimately unhealthy for markets and could lead to equity overvaluation, says Morten Springborg, global thematic specialist with C WorldWide Asset Management.

Speaking on the Soundbites podcast this week, Springborg said passive investing has become enormously popular, but that popularity threatens the very stability of markets.

“There’s a fallacy of composition here, as they say,” he said. “For individuals it’s a rational thing to do, but for the system overall this is highly unstable.”

He said the passive strategy promotes “momentum gain” where the act of investing creates gains that make further investment more attractive. It introduces a dangerous feedback loop.

“As funds go into these products, they drive up the price of the largest companies, thereby increasing the demand for the large companies even more,” he said. “So it’s an unstable equilibrium.”

Springborg said passive funds have shown trendline growth of 2% to 3% per year for the last 20 years, growing globally to about 50% of all investment flows and surpassing 65% in the United States.

“It’s been very beneficial for the users of these products, of course, because historically you got very cheap … diversification. What you do have to understand today is that that diversification is not there any longer,” he said. “Now you have a very concentrated market. Even though you are buying 500 underlying securities, it is highly concentrated.”

Increasingly, passive investors are supporting large-cap U.S.-based growth firms, to the detriment of small-cap, international value names.

Part of the problem, he explained, is that passive investments tend to be made without any discussion about valuation. And because every company in the index is bought, their values are artificially inflated.

“It is just ‘buy at any price,’” he said. “That was not a problem when passive shares were a small fraction of the overall liquidity and volumes in the market. But now passive is so big that these flows totally dominate the volumes in equity markets.”

Springborg said the value of companies in the index should be completely unaffected by liquidity in the market.

“But academic research has proven that for every 1% bid in the market from passive, the pricing impact is 5%,” he said. “The price goes up 5% if you buy 1% of the stock, on average.”

Furthermore, because liquidity scales differently across the spectrum of market capitalization (trading volume among small-cap companies is generally higher than it is among large-cap companies), the impact on large-cap stocks is greater.

“As passive grows its market share, it impacts the price-earnings multiple much, much more forcefully for the large companies than for the small companies,” he said. “And that explains, to a certain extent, why we have this extremely concentrated market today with Mag Seven companies.”

With index funds, investors buy companies they might not if they were actively selecting individual names.

“When you are a passive investor, you cannot avoid buying these companies. You have to buy the largest companies,” he said. “So you have this indiscriminate amount of liquidity flowing into the largest companies, and it will continue as long as you have positive flows into passive structures.”

Adding to the impact of passive investing, as ETFs grows in popularity, there are proportionately fewer active managers to counteract their influence. The combined impact, he said, is staggering.

“According to some calculations, the American equity market is overvalued by at least 20% because of the dominance of passive investing,” he said.

While passive investors have done well by the system to date, there is growing concern that the resulting overvaluation of stocks will ultimately be problematic.

“We cannot tell when these flows will end,” he said, “but we have to understand that what we have today is a very unstable equilibrium in markets that are predicated on the constant inflows into passive.”

Any number of economic conditions could reduce ETF flows, including rising unemployment and baby boomer retirements.

“It’s going to be a significant problem as the boomer generation start to really retire and dis-save,” he said. “The outflows when we retire are going to be massively more important than the inflows have been. And they will dominate, and therefore press down the market.”

Moving forward he suggested that passive investors should consider equal-weighted ETFs rather than those that are market-cap weighted, and should look for options that are more geographically diverse, rather than concentrated primarily on U.S. companies.

“The U.S. is 4% of global population, 25% of global GDP, but 70% of global equity market capitalization. I believe that that is unsustainable,” he said. “If you’re a long-term investor, you’ve got to diversify outside the U.S.”

He said AI is driving U.S. tech investments, and passive investing will continue to exaggerate their value even after that investment story diminishes.

“Eventually they will not be able to continue to defy gravity,” he said. “That could be one event that would question the continued rise of passive.”

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This article is part of the Soundbites program, sponsored by Canada Life. The article was written without sponsor input.