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

Why it’s having such an impact

MS: When you give an order to buy a passive ETF, there’s no discussion about valuation. It’s just ‘buy at any price.’ Now, 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. That also means that when the passive flow hits the market, there are fewer and fewer active equity holders that react to the bid in the market. And academically, we have talked about the efficient market hypothesis, stating that the value of a company is the future discounted cash flows or dividends from the stock. The value should be completely unaffected by liquidity in the market. But what recent academic research has proven is that if you have a 1% bid in the market from passive, the pricing impact is 5%. So the price goes up 5% if you buy 1% of the stock.

Why larger companies are primarily impacted

MS: In the research, Apple, at that point in time, was 186 times larger than Clorox in market capitalization. But Apple’s liquidity on an average day-to-day basis is only 35 times larger than Clorox. Which means that Clorox is many, many times more liquid than Apple. And that means that when these flows hit the market, the price impact on Apple is bigger than it is on Clorox. As passive grows its market share, it impacts the price-earnings multiple much more forcefully for the large companies than for the small companies. And that explains, to a certain extent, why we have this extremely concentrated market today with Mag Seven companies. When you are a passive investor, you cannot avoid buying these companies. You have to buy the largest companies. 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. Now the problem is that we cannot tell when these flows will end. 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. And I think it’s going to be a more significant problem as the boomer generation starts to really retire and dis-save. Because we spend maybe 40 years building our savings pool by monthly inflows into the equity market. But when we retire, we dis-save. It may be over 10 years. 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.

Who has benefited the most from passive investing?

MS: Well, it’s been very beneficial for the users of these products, of course, because you get very cheap, historically broad diversification. What you do have to understand today is that that diversification is not there any longer. Now you have a very, very concentrated market. Even though you buy 500 underlying securities, it is highly, highly concentrated. And therefore not as diversified as it used to be.

And finally, what do investors need to know?

MS: I think it is very important that you think about diversification. And you are not diversified if you have an S&P 500 ETF. If you want to go the ETF route, maybe you should look at an equal-weighted ETF and not a market-capitalization weighted. The other thing is that passive has also driven this uniqueness or exceptionalism in American equity markets, where the U.S. equity market today is 70% of global equities. I believe that that is unsustainable. The U.S. is 4% of global population. It is 25% of global GDP, but 70% of global equity market capitalization. If you’re a long-term investor, you’ve got to diversify outside the U.S.

Well, those are today’s Soundbites, brought to you by Investment Executive and powered by Canada Life. Our thanks again to Morten Springborg of C WorldWide Asset Management. Visit us at investmentexecutive.com, where you can sign up for our a.m. newsletter and never miss another Soundbite. Thanks for listening.

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