One of the key criticisms of the epochal shift to passive investing revolves around the extent to which passive vehicles are funneling large amounts of money into markets indiscriminately.
While it is undoubtedly true that the proliferation of low-cost vehicles that allow investors to cheaply express a long-term view on the broad market is generally a positive development, you’d be naive not to acknowledge that there are consequences.
One of those consequences is that the price discovery mechanism becomes impaired. Increasingly, stocks don’t trade on the fundamentals. Recall the following from Howard Marks, quoting Steven Bregman:
As Steven Bregman of Horizon Kinetics puts it, “basket-based mechanistic investing” is blindly moving trillions of dollars.ETFs don’t have fundamental analysts, and because they don’t question valuations, they don’t contribute to price discovery. Not only is the number of active managers’ analysts likely to decline if more money is shifted to passive investing, but people should also wonder about who’s setting the rules that govern passive funds’ portfolio construction.
That echoes the sentiments expressed in a now infamous letter penned by Arik Ahitov and Dennis Bryan, who run the $789 million FPA Capital Fund. To wit, from the letter:
The consequence of unrelenting inflows into passive funds is that stocks that are included in a major index receive ongoing support by the indiscriminate purchases made by these funds regardless of a company’s fundamentals. The benefits are amplified for companies that are owned by dozens of ETFs and index funds. On the flip side, those unfortunate stocks that are not included in a major index receive the reverse treatment, as active managers that tend to be fully invested are forced to sell shares to meet the onslaught of redemptions they are facing. But the worst fate is saved for those orphan securities that are removed from an index. These stocks face both indiscriminate selling from index funds on their removal date and continued redemption-related selling from actively managed funds. Unfortunately, these buy and sell decisions are entirely disconnected from a company’s fundamentals.
Ok, well with all of that in mind, consider that according to a new note out on Monday from Goldman, “the share of stock that might trade on fundamental views has dropped to 77% for S&P500 average stock from 95%” in the space of just 10 years. Here’s more:
Considering the rise of Passives, how much stock could trade on company specific fundamental views?
We believe Passive holders trade stock for different reasons than Active Managers, and at different frequencies. Passive’s decision to buy or sell stocks is often directed by broader fund flows and larger rebalances and not typically company specific fundamentals. Additionally, Passives turn over their portfolios just 3% a year vs 38% for active managers. Therefore, when considering the potential float for a stock that could trade on company specific fundamental views, we believe investors should take Passive holdings into consideration.
So that’s all fine and good on the way up. But what happens on the way down?
Something about babies and bathwater…
This further supports implementing the strategy of focusing on the accumulation of fundamentally decent companies that have been dropped from indexes. Debt free and low debt names that have cut or suspended their dividend for “good” reason(s) are prime/rare examples.
TRH
Thanks for this insight. If true, the problem for “good” companies not in indexes is the old saying: Out of sight, out of mind. If no one thinks about you your price just won’t change much. A sage professor of mine once advised me: If you want to make money in the market you need to figure out something good about a stock, a secret that no one else knows, buy the stock, and then tell the secret to everyone you meet . If you don’t share your secret the stock will never go up.