Passively managed mutual funds have attracted considerable assets in recent years, as they have consistently outperformed a majority of actively traded funds, net of fees. Backlash by active managers has been sharp, with one famed hedge-fund manager, Paul Singer, arguing that passive investing is “destructive to the growth-creating and consensus-building prospects of free market capitalism.”
Passive indexing follows a fixed investment rule while active investing follows a manager’s discretion. The most common passive rule is to invest an amount into each company that is proportional to its market capitalization (value) relative to the value of all other companies held in the mutual fund. This rule, called “market capping,” is consistent with the “efficient markets view” that stock prices properly reflect market risk.
Despite some evidence to the contrary, the main argument made against market capping is that it is dumb money, a herd mentality that magnifies the rise or fall of share prices. In other words, market cappers are bubble generators and crash enhancers.
Rhetoric aside, passive indexing will not consume all investments, despite its recent growth. Still, it is an integral part of well-functioning markets. If anything, there is still too little of it.
Let me explain why.
Fears of market capping are largely based on a misunderstanding of basic microeconomics that describes how a market equilibrium is reached. Active traders, not market cappers, are the marginal investors who set prices. If market cappers were inefficiently magnifying those prices then active managers would move completely to cash or bonds when stock prices are high and fully to stocks when stock prices are low. Moreover, if active managers could easily short sell, they would take negative positions in stocks during good times and leveraged positions during bad times. However, we do not see either of these strategies implemented at significant scale. While a baby-boomer savings glut might be pushing up stock prices, it has nothing to do with the choice between passive vs. active.
A closely related argument against market capping is that all investors can’t become passive since there would be nobody left to set prices. Of course, this point is correct, but only because it is a strawman. An efficient stock market has active traders, who do price discovery in exchange for trading first, as well as passive traders, who simply follow.
Even active management, though, is subject to competition, and so microeconomics 101 eventually takes over. The equilibrium point, where there is no additional shift from active to passive, will be reached when one simple condition is met. Specifically, active managers will earn higher returns before fees in equilibrium to account for their additional costs associated with price discovery. But, active traders will also be tied on average with market cappers after fees. The fact that most active managers, though, don’t add enough value to recover their higher fees suggests a current oversupply of active managers.
Even today, almost 60% of U.S. mutual fund assets are actively managed, with median fees around 120 basis points, or about 40 times more than the cheapest market cap ETFs. Basic microeconomics, therefore, suggests that lower quality active traders will continue to be weeded out of the market.
And here’s where things get really interesting.
While there is a sustained role for active managers, that does not mean that a large portion of assets actually need to be actively traded. If active managers can easily short stocks and bonds then active managers could efficiently set prices using long/short portfolios that generate income with no net asset value.
In other words, almost 0% of the total public value of stocks and bonds would be actively traded, after short positions are subtracted from long. If, however, active managers can’t easily short sell, then they must control just enough assets to easily adjust prices. Still, only a minority—probably well less than a quarter—of assets would then need to be actively managed.
Economic theory predicts that the march toward market-cap weighting is likely not over. That’s probably a good thing for investors and, eventually, even high-quality active traders. It’s capitalism operating at its finest.
Kent Smetters is a professor at the Wharton School of the University of Pennsylvania. He blogs at KentOnMoney.com and appears on “Your Money” on SiriusXM Radio.
The story “Why Critics of Passive Investing Are Wrong” first appeared on WSJ.com