Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 552

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!

 

Leave a Comment:

     
banner

Most viewed in recent weeks

Meg on SMSFs: Clearing up confusion on the $3 million super tax

There seems to be more confusion than clarity about the mechanics of how the new $3 million super tax is supposed to work. Here is an attempt to answer some of the questions from my previous work on the issue. 

Welcome to Firstlinks Edition 566 with weekend update

Here are 10 rules for staying happy and sharp as we age, including socialise a lot, never retire, learn a demanding skill, practice gratitude, play video games (specific ones), and be sure to reminisce.

  • 27 June 2024

Australian housing is twice as expensive as the US

A new report suggests Australian housing is twice as expensive as that of the US and UK on a price-to-income basis. It also reveals that it’s cheaper to live in New York than most of our capital cities.

The catalyst for a LICs rebound

The discounts on listed investment vehicles are at historically wide levels. There are lots of reasons given, including size and liquidity, yet there's a better explanation for the discounts, and why a rebound may be near.

How not to run out of money in retirement

The life expectancy tables used throughout the financial advice and retirement industry have issues and you need to prepare for the possibility of living a lot longer than you might have thought. Plan accordingly.

The iron law of building wealth

The best way to lose money in markets is to chase the latest stock fad. Conversely, the best way to build wealth is by pursuing a timeless investment strategy that won’t be swayed by short-term market gyrations.

Latest Updates

Financial planning

Our finances should enable and not dictate our lives

Most people would prefer to have more money than less of it. But at what point do the trappings of wealth and success start to outweigh the benefits of striving for more?

Economy

This vital yet "forgotten" indicator of inflation holds good news

Financial commentators seem to have forgotten the leading cause of inflation: growth in the supply of money. Warren Bird explains the link and explores where it suggests inflation is headed.

Shares

Emerging market equities are ripe with opportunity

Emerging markets offer compelling value compared to history and the stretched valuations of developed market equities. Investors can benefit from three big tailwinds, but only if they are selective.

Taxation

Tomorrow's taxpayers pay for today's policy mistakes

Less affordable housing isn't the only thing set to weigh on Australia's younger generations. If new solutions for pension deficits and the use of resource revenue aren't found quickly, tomorrow's taxpayer will foot the bill.

How would a switch to nuclear affect electricity prices?

The Coalition's plan to build seven nuclear power stations in 15 years faces scrutiny due to high costs and slow construction. And it is unlikely the investment would yield cheaper energy for Australian households and industry.

Strategy

Reader feedback from our 2024 survey

Articles that are easy to understand, quick to read, and credible; being able to engage via the comments section; and keeping Firstlinks free and independent are just some of the features valued by our readers.

Strategy

Have your say on Firstlinks and the topics we cover

We’d love to hear your thoughts on Firstlinks and how we can make it better for you. If you’d like to help us out in a just a couple of minutes, please take our short survey.

Sponsors

Alliances

© 2024 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.