No such thing as too many passive investors: Allison Schrager

In this piece from Allison Schrager, the dominance of passive investing and its implications for market efficiency are explored. With over 50% of Americans' investments in passive funds, a significant shift has occurred from active management, raising concerns about market dynamics and the potential risks of under-informed capital allocation. The discussion spans the theoretical foundations of market efficiency, the role of active investors in maintaining this efficiency, and the potential for passive strategies to inadvertently create bubbles or stifle innovation. The article also considers the viewpoints of finance experts and the balance needed between passive and active investments to ensure markets continue to function effectively..Sign up for your early morning brew of the BizNews Insider to keep you up to speed with the content that matters. The newsletter will land in your inbox at 5:30am weekdays. Register here..By Allison Schrager .___STEADY_PAYWALL___.US markets are doing much better than markets everywhere else, but no one seems to know why. Yes, there are theories: Perhaps it's the promise of AI, although it remains to be seen how AI will play out and who will profit. Or maybe valuations are high, and the market will come down. Or … could it be that markets are doing better because no one is really thinking about them all that much?.I know I'm not — because I own passive index funds. And I am not alone. In January, the share of money in passive funds was more than 50%. In 2010, that figure was between 30% and 40%, depending on how you measure it. It could be that markets keep rising because we passive investors just keep buying stocks no matter what the information says..There has always been a contradiction at the center of the efficient-market hypothesis: If prices reflect available information almost instantaneously, then there is no point in trying to beat the markets. This process is critical to how markets work..Markets are supposed to allocate capital to its most productive use. If the money just goes to the biggest companies, that entrenches their market power and could undermine innovation and long-term growth. If money goes to the wrong places, stocks become overvalued and vulnerable to bubbles. And even if neither of these hypotheticals is true, some active investors complain that the rise of passive money is making it harder to incorporate important information into prices and make money..Read more: BNC#6: Heystek Q&A – Cautious investing, market uncertainties, looking offshore and more.Which leads to a second paradox: For markets to be efficient, there needs to be a critical mass of investors who don't believe in market efficiency — or believe that they are smarter than everyone else. But how many is enough? Now that passive money is dominant, are there too few?.A recent research note from Owen Lamont, a longtime finance professor now at Acadian Capital, defends us passive investors. We are not distorting markets or making them less efficient. Like Switzerland, he argues, we're neutral. My next 401(k) contribution may be 5% in Nvidia (its share of the S&P 500), but it is also 0.45% in McDonalds. I am not changing relative prices — and that's what matters..Of course, if we lived in a world where almost everyone is neutral, countries run by destructive and imperial autocrats would face no resistance and make the world a much worse place. My colleague John Authers argues that too much passive investment can overwhelm the markets and make it harder for prices to reflect information..Lamont says it does not take that many people to keep markets efficient. Conditions might change, making it harder to make money if you don't change your strategy, but that's always been the case. You just need the right people in markets — the smarter ones — to keep them efficient..There is not much data available on who owns passive funds vs. active ones; there is some ambiguity about what counts as passive. But industry sources I spoke to estimate that growth in passive investment has been equally split between retail and institutional investors. Some converted to the passive religion after reading research showing that active fees weren't worth it. But a lot of the flow into passive funds is new money..Read more: Redefining AI investment: Why value investing trumps 'Picks and Shovels' – Sean Peche.The rise of passive investment coincided with the growth of 401(k)s. While the share of passively indexed money in the market has risen, to some extent this reflects new, less skilled investors entering in the market. They benefit from having a cheaper way to invest in markets, and are better off in passive index funds..To be sure, there is probably a limit to how much passive money can dominate markets. About half the money in public markets is institutional money. And while institutions are also investing more in passive funds, as a share of their portfolios institutional investors are still mostly in active funds..Institutional money managers and many financial advisers have an incentive to stay that way. Some of it is self-interest — if you are paid lots of money to manage an endowment or someone else's money, it is hard to justify your fee if you put it all in the S&P 500. Institutional investors may also have needs that require more obscure assets or correlations, and need active management to get that exposure..That said, Lamont is probably right: Having about half of all money invested actively is enough to keep markets efficient. Even as little as 10% actively managed may be fine too — as long as there is money to be made from being a stock picker in public markets, someone will do the work to price in the information..A bigger threat to efficiency is private markets. They promise higher returns, but offer no transparency or liquidity (which is arguably their appeal), so there is no way for investors to price in information. If they attract more of the talent and money, that could leave public markets less efficient for passive investors like me. For now, however, they are still mostly efficient — which does not mean, of course, that they make any sense..Read also:.BNC#6: Sean Peche – Unlocking the power of AI, transforming industries and investing wisely🔒 Europeans need to shift from cash hoarding to investing: Chris BryantWhy should I consider investing in gold?.© 2024 Bloomberg L.P.

No such thing as too many passive investors: Allison Schrager

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