This article reflects the opinions of its author and not necessarily those of ShareSoc.
A growing trend of flows away from active investors to passive index trackers may damage the price discovery process and efficient capital allocation.
My attention was recently drawn to this article in the Financial Times. It reports that $450bn was withdrawn from actively managed stock funds in 2024, with $1.7tn flowing into ETFs (though it is not clear what proportion of that ETF money has been allocated to passive, index tracking ETFs).
It strikes me that this poses a real problem to the traditional capitalist model which relies on an efficient allocation of capital to businesses. Only active management can lead to proper price discovery.
Let me explain: the so called “magnificent 7” stocks comprise 36% of the S&P 500 index. That means that for every $1 put into S&P 500 trackers, 36c is automatically invested in those stocks. Given that there is a limited supply of shares in the mag 7 stocks, that will tend to push their share prices higher, irrespective of the performance or prospects of the underlying businesses. This leads to an even greater concentration of the S&P 500 in a very small number of leading stocks. That implies that the capital flowing into passive ETFs is not allocated efficiently.
This process could lead to a vicious circle, wherein increasing amounts of investors’ funds flow into passive ETFs; ever more shares of the largest stocks get bought, depriving smaller businesses with greater potential of the capital they need to grow.
Another recent FT article causes further concern. This article states that US regulators are pressuring the ETF giants (BlackRock, Vanguard etc) to remain passive investors in banks that they hold major stakes in. That removes any stewardship functions from those investors and lessens the accountability of managements of those banks to their shareholders. This is a further blow to an efficient capitalist economic model.
Only active funds and other active investors can bring about proper price discovery and more efficient allocation of capital, by applying judgement to where their money is invested.
I don’t have an answer to this conundrum – but would be interested in others’ thoughts, so do feel free to comment below.
Mark Bentley, Director, ShareSoc
New money goes into stocks in proportion to their free capital float. So every $ put into S&P 500 trackers is invested into every constituent in exactly the same proportion relative to its size.
There is no valid reason why a large cap should have a different price elasticity than a small cap, so while the new money (if indeed it is new money and not a reallocation from active which would be consistent with the theme of the article) may have an impact on overall share prices it will have zero effect of relative share prices or on concentration.
To the extent a stock is overvalued or undervalued, the percentage of price-takers (passive investors) relative to price makers (active investors) demonstrably increases the capacity of the price-makers to engage in price discovery to erode such anomalies.
This leads to the much-discussed (FT’s Robin Wigglesworth) concept of “peak Passive” or the equilibrium point where market inefficiencies make active a more attractive proposition than passive at the margin. Nobody know precisely where such equilibrium lies, but the SPIVA Scorecard suggests we have a way to go yet.
The blog looks specifically at the S&P. There is certainly an issue in index investing in that it tends to ignore the small and micro caps – but that has always been an issue with active funds and with institutional investors too, so no real change.
Ultimately there are two elements at play here:
1) The prices of the Mag7 stocks are decided by active market participants, not by passive ones. Some (Stuart Kirk) would even argue that stock prices are a function of market-perceived risk/reward and are impervious to capital flows. I wouldn’t go that far.
2) If stock prices overall are too high, that is a function of the aggregate amount of capital coming into the market (regardless of whether that is invested actively or passively).
Of course, nothing here says that the market can’t get ahead of itself and that we’re not massively overvalued here…
Fully agree that the agreement by Blackrock, Vanguard et al to abrogate their stewardship responsibilities is very concerning. Passive investing should absolutely NOT be associated with zombie stewardship.