At some point in the next nine months a historic milestone will be passed. More than half of managed equity assets in the US will be run on a passive basis (for global equities the figure is 38%). At the current rate we forecast that this will happen sometime in January 2018. We don’t think that there will ever be any reversion back past this point, so from here on the majority of equity AUM in the US will be passive. In this short note we consider what this means.
That’s from Bernstein’s Inigo Fraser Jenkins and team. The charted version looks like this:
While the less intimidating version points out that when other holders of equities — retail, corporates holding their own stocks, SWFs etc — are taken into account, expressed as a share of market cap, passive is “only” 14.5 per cent, according to Bernstein.
And yes, this is the same Bernstein team which previously suggested that passive investing was worse than Marxism and ranked capital markets thus:
- Capitalist society with functioning capital markets
- Capitalist society with predominantly passive capital markets
Their argument is/was that markets exist to allocate capital and passively dominated markets won’t allocate it very well since there won’t be active managers doing the necessary fundamental legwork. Or: “In a Marxist society at least someone is doing the planning of capital allocation, but in a predominantly passive market then the capital allocation process is done by a marginal participant.”
There are numerous potential problems with this which have already been raised. For one, there is an argument, put forward by Credit Suisse’s Mauboussin earlier this year, that the shift away from active might actually be good for market efficiency:
Investors are shifting their investment allocations from active to passive management. This trend has accelerated in recent years. The investors who are shifting from active to passive are less informed than those who stay. This is equivalent to the weak players leaving the poker table. Since the winners need losers, this can make the market even more efficient, and hence less attractive, for those who remain. If you can’t identify the patsy, or weak player, it’s probably you…
Small and unsophisticated investors should build passive portfolios, with an emphasis on asset allocation and low cost. Sophisticated investors should seek active managers in asset classes with high dispersion. There are ways to assess money managers beyond past performance that may shade the odds in your favor
But even if you buy Bernstein’s side, their operative word is “predominantly” since the argument is that at some advanced level of passive domination the capital allocation function of the market will be damaged. It’s an argument that makes logical sense for an undefined level of passive domination. More so, it’s unclear that a level high enough to be damaging to the market will be reached — arguably as soon as the market starts to become dysfunctional it will pay active managers to jump back in. That’s what those like Burton Malkiel who are passive fans would say, anyway.
As you’ll have already seen, Bernstein have said it’s not clear at what point passive will start to harm markets as they force them to become more correlated: “By definition, passive flows of capital, given that they seek to emulate or replicate what has already occurred must be backward looking”. It might, so the argument goes, already be happening but “even if such thresholds did in fact exist… it would be impossible to know that they had been breached in real time.”
That must make it all the harder for them to admit that the new, majority from some points of view, presence of passive investing isn’t going away — mostly because costs matter and that’s where passive shines — and there isn’t a bubble in passive by any normal definition of the term.
So, yes, investors might be becoming more lazy — operating under assumptions that simple ratio-based investments like 60:40 rules are neutral rather than active investment decisions — and that in itself might replicate bubble-like behaviour.
And yes, as we hit that 50 per cent level above, “the implications for the functioning of the market and the process of capital allocation in society are, at this stage at least, unknown.”
But the best guess, we suppose, is that somewhere between Bernstein’s Silent Road to Passive Investing Serfdom and Matt Levine’s Best Capital Allocating Robot (which has solved the socialist calculation problem, rendering markets as we know them obsolete) is where we’ll live for at least a while yet.
The hare gets rich while you don’t. Back the passive tortoise – FT Alphaville
Dear hedge funds, it’s not you, it’s the fees – FT Alphaville
It’s a good job the only word that rhymes with passive is massive – FT Alphaville
The relentless bid, explained – Josh Brown