Passive investing: Confusing circumstance with skill in a momentum-driven market

Merryn Somerset Webb discusses the rise of passive investing and how it is becoming a popular choice for many investors. Somerset Webb argues that passive investing is not as diversified or market neutral as it is often perceived to be. Most passive funds are heavily weighted towards US stocks and technology stocks. Further, Webb also explains that passive investing is simply momentum investing and is subject to change as market conditions change. This article highlights the current state of global debt levels and how financial repression may impact the stock market in the future. Concluding that while stock market indices may struggle, good active funds will not.


It’s time to switch from passive to active investing

By Merryn Somerset Webb

Last week, Marie Kondo announced she had given up on tidiness. It turns out that she found it easy to be immaculate because she had no kids. Now she has three.

What next you might wonder. Will social media influencers discover they found it easy to be thin and beautiful mostly because they were young? Will tech investors learn it was easy to get rich because interest rates were too low for too long? Will the managers of passive investment funds find they were successful only because market momentum was on their side?

These confusions of skill with circumstance seem all but a given. But the last has so far received too little attention.

This century has seen a stunning rise in passive investing. It’s hard to be sure how much of the global stock market is held passively, but the best estimates on the US put it at not far off of 40%, and lower but rising elsewhere. This makes a lot of sense. Passive money management is an almost perfect business model. It offers a product that has provided huge benefits to consumers — after fees, passive funds have outperformed active pretty much every year for the last 20. It doesn’t cost much to do — and what costs there are are mostly low and fixed. No performance-fee-demanding managers required here. With volume, you can make investing both cheap for consumers and vastly profitable for your firm. No one loses — and if the industry is to be believed, no one will.

Let’s think about how this happened. Most people like to believe that when they choose, say, a passive global equity fund, they have chosen something nicely diversified — a bit neutral even. It isn’t so. First they have chosen something very heavily weighted to the US: The MSCI World Index is nearly 70% made up of the US market, for example. They’ve also bought something very heavily tech based: 20% of the index is information technology, and the top three stocks (which make up nearly 10% of the entire world index) are all US technology companies. Diversified? Market neutral? Not even the tiniest bit.

You can see how this happens. Most indices are market capitalization weighted — so the bigger a firm’s market cap is, the more of it they hold. And if a group of stocks goes up, the passive funds buy even more. That makes them go up more, then they buy more … and so on.

Then, of course, the active managers get caught in the trap. If they don’t want to constantly underperform the index, they have to start buying the stuff at the top too, however mad it might feel. Nightmare.

The key point is this: Buy an index that is constructed in such a way that the greater a company’s market capitalization, the more of an index it makes up, and you can’t help but buy high and sell low. In the technology bubble of the 1990s, passive investors were, as researchers at Cass Business School put it at the time, “effectively forced” to buy bigger and bigger stakes in overpriced companies. They were forced to do the same during the growth bubble of the last decade. This all reached nutty extremes in 2009 and 2021 (historians will refer to 2021 as our blowoff phase) with the biggest five stocks in the S&P 500 making up some 20% of its total.

The truth is that passive investing is simply momentum investing: Buy in and you get to hold lots of stuff that has done well recently (and the more overpriced they are, the more you hold) and not much of the stuff that hasn’t. That can be just fine — until conditions change. And change they have. 

The stock market winners of the last few decades have been companies that have found the conditions of those decades rather brilliant: firms that have benefited from very low interest rates, easy credit, the lack of need for tangible investments (as everything gets made in China), off-shoring and financial engineering. The indices are jammed with those winners.

But it seems clear that the dynamics of the last 40 years are at least in part reversing. Interest rates aren’t going back to near zero; the new obsession with supply-chain resilience means companies (and countries) need their own factories; and we have all lost interest in the idea that growth is somehow priceless in a stock market context. The winners of tomorrow are not the winners of yesterday — so why hold a fund that mostly tracks the latter?

There is something else to take into account on top of this, says market historian Russell Napier (see here for my Merryn Talks Money podcast with him). We live in an age of extreme debt: As interest rates have fallen to 5,000 year lows, so have global debt to GDP levels risen to 5,000 year highs. The obvious (and only) way for governments to deal with that is via financial repression. That means keeping interest rates below inflation in an effort to gradually erode the real value of the debt — and it means forcing savers and financial institutions to buy government bonds in volume even if they cannot get a real return from them (since the yield is lower than the inflation rate). Neither of these things are good for equities.

Still, this all comes with good news. Stock market indices may well languish for years as the old winners fade and fade again (the top four stocks in the S&P 500 are all tech stocks and together still make up 15% of the index). But good active funds will not.

In 2022, for the first time in a long time, active managers outperformed passive managers, particularly in the US large cap space. And if those managers dump the old winners and buy the new, they may be able to keep outperforming.

Look back to previous periods of financial repression and inflation, says Napier, and it is obvious what has done well: stocks that have started the period cheap. That was most of the market in the late 1940s and 1950s. And it was niche bits and bobs in the 1970s; even as the wider market worked on destroying most investor wealth, small caps and resource stocks hugely outperformed.

So what is it now? GMO’s Ben Inker has some answers — global value stocks, emerging market value stocks; Japanese and European smaller-value stocks and resource stocks. Napier also points to the UK and to emerging markets excluding China. No one points to the constituents of the S&P 500, the thing that most passive investors hold most of and the one thing that, says Napier, is still “grotesquely overvalued.” 

Just as Kondo found out that having kids changed everything for her, the big passive players may be about to find that the reversal of market momentum does the same for them. The future looks messy for both.

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