Passive attack: the greatly exaggerated death of price discovery

Yay, the endlessly discussed passive-versus-active debate has been in the news again, with recent Morningstar data showing net assets in passive funds exceeded those in active ones for the first time ever in December.

This has been inevitable for a long time, as net inflows have favoured passives since 2005, according to Morningstar.

And you can feel it intuitively. I’m probably in a bubble within a bubble, but most of the good advisers I know are now dyed-in-the-wool Bogleheads when it comes to their investment proposition.

It makes sense, and it’s part of the reason our sector is so brilliantly democratic.

Microfirms understand it’s essentially impossible to deliver true alpha for your clients reliably (if at all) when you can’t get them close enough to the doomsday machine. But we also know that’s OK, because a sensible, disciplined smart-beta approach will probably beat the pants off any shiny-loafered private-banking lizard person and their pretend-bespoke structured products.

The primacy of passive funds is changing the behaviour of markets, which matters even if the chances of it breaking your model remain small

But passing this threshold does feel a bit significant and crossy Rubicony, and it’s got people all hot under the collar again about what it means for the behaviour of stock prices, as passive becomes the dominant model.

The ultimate fear is that without the price-discovery mechanism provided by active management, the whole thing breaks – ‘chaos without limit’, as American investor John Bogle himself put it back in 2016. Picture a Hieronymus Bosch painting but with more Teslas.

We return to this question semi-regularly in our investment committees. All the evidence suggests we’re still a long, long way from the inflection point where markets become so inefficient there’s not enough price discovery for them to function properly.

Although it’s very hard to be definitive, given all the moving parts and feedback mechanisms, Bogle suggested this point could be reached when around 90% of the market was indexed.

The ultimate fear is that without the price-discovery mechanism provided by active management, the whole thing breaks

But market share is only part of the story. If you look at trading volumes, because active funds are (obviously) traded a lot more, you’d expect even a tiny minority of them to generate a significant amount of price-discovery-creating activity.

Then there are the natural feedback loops that, logically, would kick in as markets became less efficient. As Tim Hale argues in his book Smarter Investing, “once markets begin to become inefficient, easier profit opportunities will exist, encouraging active managers to re-enter the fray”.

Nevertheless, it is valid to keep asking the question, as theory becomes reality. Because it is true to say the primacy of passive funds is changing the behaviour of markets, which matters even if the chances of it breaking your model remain small.

For example, a recent study from the US National Bureau of Economic Research said the increased use of indexing has a measurable impact on the relationship between news and the reaction of stock prices, effectively deadening the transmission mechanism.

One of my fears for retail investors is the risk of them being stuck one paradigm behind reality due to the complacency of their advisers

You can see how big players in active management might use this to try and put the heebie-jeebies up everyone. But that feels a bit disingenuous when those same active managers have been consistently failing to beat their benchmarks since year dot, even back when they had all that lovely price sensitivity to play with.

Mainly because they were trousering excessive fund charges (which the rise of passive, as it happens, has driven down for the end investor).

In the end, nobody knows – not really. It’s all interesting from an academic standpoint but I don’t think there is anything new and actionable here. We’re still probably a long way away from the (largely theoretical) point where we all turn into a Bosch painting.

But I reserve the right to keep worrying about this, because one of my fears for retail investors is the risk of them being stuck one paradigm behind reality due to the complacency of their advisers.

I do sometimes wonder if advice firms have got trapped by lazy thinking. ‘Passive good, active bad’ gets repeated so often it feels like a religion for some

I know it’s different, but I think a lot about the kind of intransigence and creep that led to people having their life savings lifestyled into long-dated gilts just before central banks took a wrecking ball to the credit market.

I approach everything in retail investment with a degree of learned scepticism and something’s only right if the data continues to support it, not just because you believe it to be right.

The best thing for clients now probably won’t be the best thing for a 30-year holding period. I do sometimes wonder if advice firms have got trapped by lazy thinking. “Passive good, active bad” gets repeated so often it feels like a religion for some.

Even if the balance of probabilities remains stacked one way until I shuffle off into retirement (which seems highly plausible), I like to think I’ll carry on talking myself out of this approach, and back in again, at every investment committee meeting, based on the available evidence. We all know nothing is mathematically impossible in investing.

This article originally appeared in Money Marketing, February 2024