How Passive Investing Growth Affects Markets

Vyacheslav Dvornikov

Dec 2, 2024

Several giants of the financial industry have recently spoken out against passive investing. As demonstrated in the Apollo Global Management report based on empirical data, the growth of passive investing has contributed to reduced liquidity (due to decreased trading volumes: passive investors do not trade), as well as increased volatility and concentration. We discussed why increased concentration reduces the expected market return here. According to Apollo, passive equity funds account for nearly 60% of the US market, and 50% outside the country.

Apollo illustrates why the growth of passive investing distorts asset prices, making large companies increasingly expensive without considering fundamental factors.

Active investors can take both short and long positions, while passive investors can only take long positions. The flow of investor funds from active to passive funds will increase the value of expensive overvalued companies more than undervalued ones, and here's why.

Imagine there are two companies, both with a fair price of $1 billion. But one is valued by the market at $500 million, and the other at $2 billion. When an index fund receives $5 to invest in these two companies, it will invest $4 in the $2 billion company and only $1 in the $500 million company. The problem worsens if the new money invested in the index fund was previously in an active fund.

When the volume of funds under management by passive investors increases in the market, active investors in short positions are more easily "squeezed out". This, in turn, reduces investors' willingness to open short positions necessary for the market to better assess asset values. The most famous short squeeze occurred with holders of short positions in the shares of the American video game retailer GameStop in January 2021. Private investors, united on the Reddit platform, "pumped" GameStop shares, leading to significant financial losses for some major "bear" players, particularly hedge funds Citadel and Melvin Capital.

The GameStop example clearly illustrates the rise in volatility. Before falling, the stock rises sharply because when it starts to rise and short sellers need to add margin, and they either don't have the money or are limited by limits, they start buying stocks to close positions. As a result, the price rises even higher. And then, accordingly, falls by an even greater percentage.

Apollo points out two factors in the growth of passive investing. The first, well-known, is related to the growth of assets under management of index ETFs. The second, less discussed, is related to the US Pension Protection Act of 2006, which automatically enrolled employees in programs like 401(k), where employee contributions are co-financed by employer contributions.

This led to a decrease in assets in pension programs that provide fixed payments after retirement. Pension fund managers of such programs leaned towards active management. Meanwhile, employees within 401(k) and other programs more often chose passive management.

Citadel's head of government and regulatory policy (billionaire Ken Griffin's hedge fund) Stephen Berger, at a conference organized by the Federal Reserve Bank of Cleveland and the Office of Financial Research, stated that passive investing creates financial stability risks, although it provides inexpensive market access for many investors, which is considered a "very positive" fact.

But the success of passive management, according to him, "depends on the presence of active managers who conduct research on fundamental indicators to determine what is undervalued, what is overvalued. And then present these theses to the market in a way that supports efficient pricing and, consequently, ensures optimal capital allocation in the economy and assets."

Berger complained that in some cases regulatory oversight "hinders the reduced number of active managers from continuing to do their job, which they should do," which can create problems with asset valuations.

News that the structure of the stock market has changed has poured in abundantly. The credit for understanding this fact seemingly belongs to the famous investor David Einhorn, the same one who first spoke about Lehman Brothers being doomed. Einhorn created his fund Greenlight Capital in 1996. Since 2015, he has shown not very good results: two negative years (2015 and 2018) and two mediocre ones. His strategies stopped working. Einhorn says it took him five whole years to understand what was happening. And in 2019, he figured it out. He explains how it happened in the February Bloomberg Masters of Business podcast. The same was confirmed to us in a private conversation by his fund's employees.

The key question, however, is not only to realize this but also to adjust the investment strategy accordingly. Apparently, this was achieved, as the results since 2019 have been outstanding again. (And overall, since 1996, good: the period of failure did not kill the return since the fund's inception, which now stands at over 13% annually.) So what do Einhorn and the fund's specialists say about this? Firstly, it is necessary to talk about the market being fundamentally broken at every corner. Secondly, the fund's analysts had to tighten the criteria for selecting stocks and choose even more undervalued ones than before. Because now there is no hope that if the market underestimates the profit potential by 20% and the multiplier is undervalued by 20%, it will lead to a 50% increase in the stock if the profit exceeds expectations and the multiplier corrects. On the other hand, Einhorn's fund is concentrated and needs to find only 15 stocks, and that many can be found. Thirdly, it is better to choose issuers who buy back shares, because then, for the stock to grow, no market players' actions are needed — it will grow on its own due to constant buybacks and a reduction in the number of shares on the market.

I would note that recently the number of companies resorting to buybacks in the US has increased significantly, so this condition does not greatly limit the fund. I also see in its portfolio a fairly large share of investments outside the US and even in Europe, which is not considered a good market. Up to cement plants in Italy. Perhaps, in terms of market structure, it is easier to invest there.

And I'll add a few quotes from Einhorn. Passive funds have turned from price takers into price makers. And such: A bargain that is always a bargain is not a bargain.