Myth-buster series: Passive funds won't destroy efficient markets

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This is the third article in ETF Stream's myth buster series, which looks at myths surrounding passive investing.

Inigo Fraser-Jenkins, an analyst at Bernstein, made a splash last year when he argued that 'passive investing is worse than Marxism.' His argument was that a largely passive stock market will no longer be able to allocate resources sensibly, so we'd be better off with a Communist central planner making those decisions.

It's an interesting argument, but I think it's wrong. Even though money will continue to shift into passive investments for some time to come, I doubt that markets will be significantly less efficient than they are now.

What are efficient markets anyway?

Before we go any further, let's quickly clarify what efficient markets are. The efficient market hypothesis (EMH) says that a company's share price should represent all the information and analysis that is available for that stock at any one time. If new information comes to light, then the share price should change.

The rise of the EMH is one factor behind the huge growth in passive investing. If markets are 100% efficient, it should be impossible to beat the market, and if it's impossible to beat the market, you might as well invest in plain vanilla passive funds that allocate money on the basis of company market caps.

The problem with passive

But if the whole market is held by passive investors, how can new information be incorporated into share prices? For the market mechanism to work, you need investors who respond to new information and who are also analysing a company in depth and looking for new information and insights.

This would be a valid concern if there was any likelihood of the whole market, or nearly the whole market becoming passive. But I don't think that's ever going to happen.

For starters, the market is more active than you might think. Index funds, including passive ETFs, still represent less than 20% of global equities, according to BlackRock. What's more, we shouldn't forget that a large proportion of equities aren't held by fund managers whether active or passive. Stocks are also held by pension funds, insurance companies, direct retail investors, and other companies with stakes in a business.

We also shouldn't forget the dividing line between passive and active is a bit blurry. Passive isn't just about investing in a fund tracking the FTSE 100 or S&P anymore. Strictly speaking, smart beta funds are passive not active because the stocks are still selected according to a rules-based process, but they feel more active than a Footsie tracker. And even if your portfolio is wholly comprised of passive ETFs, your overall asset allocation decisions - which markets to invest in - are still active.

Perhaps more importantly, if we do ever get to a stage where 70% of the market is passive, that should offer exciting opportunities for active investors. If 70% of money is just following existing market caps, it'll be easy to spot companies that are clearly under-valued - paying high yields or

trading on low price/earnings ratios even though profits are growing fast.

Because of that, I'm convinced that a self-correcting mechanism will kick in if passive investing truly starts to dominate the market. That self-correcting process might take a while and you might argue that such a market - where it takes a while for share prices to react to circumstances - wouldn't be truly efficient. And that's fair comment. But I'd argue that even the S&P500 isn't 100% efficient now, and anyway, the self-correcting mechanism I've described should at least mean that the market will allocate resources more effectively than Marxist central planners.


There's also an aspect of passive investing which helps to make the market more efficient, not less. That's the process of stock lending which is an essential part of the shorting process. When an investor wants to short a stock, he normally borrows that stock and sells it immediately. He hopes that the share price of that stock will then fall, so he can buy the stock back more cheaply when he has to return it to the stock lender.

Currently around 65% of loanable assets are provided by passive investors, and as Peter Sleep, Senior Investment Manager at Seven Investment Management says: "By contributing their assets to the stock lending market, passive investors are helping prevent individual securities from getting over-valued. This allows short sellers to borrow from a plentiful inventory of shortable assets."

The investors who short stocks aren't traditional passive investors driven by market cap, but they don't just include active hedge fund managers. Sleep says that some smart-beta passive investors are also shorting stocks.

So in summary, I don't think markets are 100% efficient now, I don't think the rise of passive investing is making them a lot more inefficient, and I don't think passive is worse than Marxism.

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