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Passive investing is bad for capitalism

While every economic system has its drawbacks, capitalism, since its inception 700 years ago, has outperformed the alternatives. While many have been left behind at various points in time, capitalism has demonstrated its merit in allocating society’s resources better than the decisions of a collective few.

But capitalism’s edge in efficiency doesn’t come without costs. One of its downsides is the unpredictable nature of business cycles. It seems to me that before the first quarter ends each year, most economic and financial market forecasts produced at the end of the prior year end up in the recycling bin as forecasters react to new and differing circumstances. 

While this is one of the prices paid for living in a market-based system for allocating resources, why does it happen? And more importantly, what can we learn from it and why is it relevant?

A complex and adaptive system

While predicting rational decisions is possible, it’s the unexpected or surprising decisions of some and the subsequent effects on the many that typically upend economic and financial market predictions.

Capitalism requires unsuppressed price signals for resources to be allocated efficiently. Those signals help create equilibrium between natural market forces, specifically supply and demand, for everything from the price of gum to the price of automobiles, to borrowing costs, to stock and bond prices. Society, from consumers, to business owners, to investors, is constantly altering its behaviour based on changes in prices.

Economists would call this a complex and adaptive system. It’s complex because hundreds of millions of people make dozens of choices a day. It’s adaptive because changes in prices lead to changes in behaviour. More interestingly, given humans have emotions and subconscious biases, sometimes our choices are made simply based upon the behaviour of others, influencing what may have otherwise been a rational decision. The combination of capitalism’s complexity and adaptiveness often leads to radical and surprising outcomes.

Relevance for today

The policy response by global policymakers to the global financial crisis in 2008 was to reduce interest rates and inject capital into financial institutions. Rates were suppressed to historically unnatural levels for over a decade as money velocity fell and deflation risks mounted. None of this is new to you. 

However, it’s important to remember that interest rates represent the price of time and the cost of capital. Rates are the first hurdle that must be cleared in every capital allocation decision. Yet their price was not a function of natural supply and demand. 

Years of interest rate disequilibrium blunted capitalism’s price discovery process. But while we’ve yet to realize overdue corrections in the economy and financial markets, that doesn’t mean we won’t. 

The socialization of capital losses in the post-GFC period beautifully paved the pathway for the massive growth of indexation. Investors are willing to pay a fee for the prospect of active managers limiting their downside, but they see no reason to do so when central bankers do the job for them.  

That probably reads like a whiny, biased perspective from an active manager who’s lost share to passive vehicles. Fair enough. However, with passive vehicles today representing over half of investable assets and the bulk of incremental investment capital, inefficiencies continue to grow.

When unencumbered by suppressed interest rates, financial markets push money toward enterprises with the highest risk-adjusted return on capital prospects and pull it from the weakest. This is Wall Street’s version of natural selection, and it’s capitalism at work.

But that isn’t what’s happening today. A lot of capital is being allocated based on market cap rather than on which opportunities may offer the best risk-adjusted returns. Indexing is momentum investing, accelerating the accrued financial market and economic inefficiencies leftover from the 2010s and pandemic-led stimulus. 

Yes, some of the largest index constituents are high-returning businesses. But that doesn’t mean they aren’t wildly overvalued due to the new plumbing of finance and the growing disconnect between price and fundamentals. Perhaps more importantly, many of the companies attracting the most capital may face a significant risk of obsolescence from artificial intelligence.

Conclusion

Our capitalist system has proven the most efficient means of resource distribution. However, it requires untrammeled market forces to deliver correct price signals. When those signals are distorted, it creates problems.

Humans sometimes make irrational decisions, and as business cycles age, people tend to make more of them as they seek to get rich quick. It’s important to consider that factor when managing other peoples’ wealth.

 

Robert M. Almeida is a Global Investment Strategist and Portfolio Manager at MFS Investment Management. This article is for general informational purposes only and should not be considered investment advice or a recommendation to invest in any security or to adopt any investment strategy. It has been prepared without taking into account any personal objectives, financial situation or needs of any specific person. Comments, opinions and analysis are rendered as of the date given and may change without notice due to market conditions and other factors. This article is issued in Australia by MFS International Australia Pty Ltd (ABN 68 607 579 537, AFSL 485343), a sponsor of Firstlinks.

For more articles and papers from MFS, please click here.

Unless otherwise indicated, logos and product and service names are trademarks of MFS® and its affiliates and may be registered in certain countries.

 

10 Comments
Dave Findlay
March 24, 2024

Great article, which its on a real structural issue in equity markets.

Scenario 1:
Imagine being an active fund trader, having done your analysis perfectly (supposing that was possible) and allocating your risk capital accordingly ... and then being completely run over by passive flows because Vanguard or Blackrock rebalanced one of their target-date funds to sell a big tranche of shares and buy bonds (don't tell anyone, but I have a feeling the "Volmageddon" period in August last year was triggered this way). You and others like you stop bothering with the fundamental analysis after a while and start looking at what the big passive funds are doing, and how the indices are constructed, to try and front-run them. After a while the fundamentals stop mattering, because nobody's looking at them.

Scenario 2:
Imagine a market where a large portion of flows are for passive, long-term holdings (like our super, for example). The shares purchased via those flows are effectively removed from the market float, as they're unlikely to be sold for any reason for a long, long time (until the member reaches retirement and wants to start drawing down to consume that wealth). That means that the remaining active investors are buying and selling a smaller and smaller float, over time, which would mean bigger price swings (ordinarily), but for the fact that the passive buys are still happening. The relentless, upward movement is not connected to any fundamentals, until the passive flows reverse (like during a COVID crash, for example). At that point, the buy-side orders from active investors are exhausted almost instantly and price goes into freefall.

Passive investing is great as long as you're the only one doing it and everyone else is handling price discovery for you. Once that stops happening en masse, then passive investing becomes just a self-reinforcing process that cannot account for the impact of its own behaviour.

David Toohey
March 22, 2024

I think the comments are mostly spot on, but there's one point of view that's missing.

Let's for a moment agree that passive investing is indeed bad for capitalism. However, the proper functioning of capitalism is not free.

Just like government services are not free either. We prefer law and order, clean and cultivated public spaces, and road infrastructure, etc compared to not having these. But there's a cost, it's called tax. We mostly let governments run themselves, but every now and then they are called to account and expenditures are reduced.

Likewise, the mechanisms by which capital markets function are the actions of the active managers who attempt to discern the good investments from the bad. These managers charge a fee for their services and investors willingly pay for this. Or alternatively, investors minimise their costs by investing passively. If the return from active management is insufficient to justify its cost, then more investors will invest passively instead of actively, which is what is happening now.

One the other end of the spectrum, it is irrational to expect that passive will become 100% of the market, given that at that point the price discrepancies for active managers to exploit will become obvious and large, resulting in a handsome payoff for active management.

So passive investment can become larger, and it will result in pricing distortions which is bad for capitalism, but only up to the point where the effort to profit from those distortions can be exploited cost-effectively by active managers.

Here's the main point: the resources expended by the economy to achieve capital efficiency by active management is a dead weight cost to the economy. There is an economic gain from the move to a higher proportion of passive management by reducing that dead weight cost.

So, our capitalist economy is telling us that there's been too much active management until now, given that a capitalist economy tends to move towards the optimal allocation of resources.

James
March 22, 2024

The amount of active trading occurring in major markets is still well above that required for price discovery, and has remained fairly stable over time. There are also market makers and hedge funds, and derivatives markets. There is still a huge dispersion of returns for active managers to take advantage of, but history shows that active managers have always struggled to consistently add value no matter what the market does.

Adrian
March 22, 2024

Yes agreed James, these people who say otherwise either don't really get it, or are frustrated fund managers facing an existential crisis.

Steve
March 23, 2024

Fully agree James. Further, is there any proof that if passive investing disappeared and we had to go to the old days and invest directly or use a managed fund that the allocation of these funds by active managers would be significantly different than we have today? If not, what is the point of the argument?

Steve
March 22, 2024

Passive investing is quickly becoming the latest momentum play for growth-oriented investors. I tend to agree with Dave. While the flows are net positive, all good. Once the flows become net negative and the air starts coming out of the balloon at an increasing rate, we will have to see what transpires next. Who knows - maybe another Nifty Fifty!

SMSF Trustee
March 21, 2024

Passive investing IS the result of "untrammeled market forces''. I'm not aware of any government interference or regulation that forces anyone to select a passively managed fund. In fact, I make the choice freely to use some in my fund. Far from being spot on, I find this article to be full of holes. EG the implications for the world economy of the untrammeled capital misallocation that produced the GFC was low potential growth rates and low inflation for a decade requiring very low interest rates. All very natural outworkings of the medium to long term capitalist cycle, which central banks had to follow. (Total myth that they set rates lower than natural forces would have had them.) And yet the article claims that this has distorted capital. And even if there has been an element of central banks running rates a bit lower than the 'lower for longer' neutral rates that were needed, it hasn't established at all a link between that and passive investing! 

John
March 22, 2024

SMSF Trustee, I'd suggest a read of Edward Chancellor's excellent book - The Price of Interest: The Real Story of Interest, to help understand why the views expressed in this article may very well be right in time.

SMSF Trustee
March 23, 2024

I know about Chancellor's work. Seems to me he presumes the conclusion simply because rates were historically low.

George
March 21, 2024

This article is spot on. In essence, passive investing is auto-directing money into certain areas, at the expense of others, and that distorts the allocation of capital, and is likely to be leading to significant misallocation of capital. The ramifications are profound, but nobody is listening in a bull market!

 

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