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Ideas Farm: Passive saturation?

Passive funds’ share of the market may be materially bigger than thought. What might this mean?
November 11, 2022
  • Models failed to reveal passive's market sway
  • (But no one seemed to notice...) 
  • Lots of idea-generating content

It turns out that passive investors own a whole lot more of the stock market than anyone thought. That’s according to a recent paper called ‘The passive-ownership share is double what you think it is’ by Alex Chinco of Baruch College and Marco Sammon of Harvard Business School, which concludes that passives’ share of the US stock market amounted to at least 38 per cent in 2020. That’s a pretty huge jump from other estimates, such as the 15 per cent calculated by the Investment Company Institute. 

The authors’ methodology is worth going over. The pair went beyond the assumption that it is only index mutual and exchange-traded funds that make up the passive universe. They analysed the closing trading volumes of companies added or removed from indices on “reconstitution days” – days when benchmark constituents are updated to ensure correct representation – to also work out the ownership of direct indexers (those who buy all the underlying shares in an index directly, rather than via a fund structure) who benchmarked against the S&P 500, Russell 1000 and Russell 2000. 

This research comes at a time when the growing power of index fund managers is a very hot topic. The big beasts of the market – BlackRock, Vanguard and State Street – have come under fire from various quarters for their growing (and arguably deleterious) influence over corporate outcomes through their increased voting power at listed companies. Current proxy voting set-ups don’t have the best press, with retail and institutional index fund investors complaining that the structures leave them with little real say on issues ranging from directors’ pay to environmental, social and governance policies. We explored this debate in a cover feature at the end of last year (‘The growing power of passives’, IC, 31 December 2021).

This is a narrative that the managers are – obviously – keen to fight back on. Last week, BlackRock chairman Larry Fink put out a letter to clients and chief executives on proxy voting. He said that the company’s “voting choice” capability was now used by clients on a quarter of the company’s $1.8tn (£1.6tn) in eligible assets under management, and argued that pushing this process forwards “can enhance corporate governance by injecting important new voices into shareholder democracy”.

To an extent, Chinco and Sammon’s research perhaps supports the index giants’ position that there is little to fear from passive funds’ growth and the possible market impact. As they note, “if the true passive ownership share is actually double what people thought it was, how much damage could it really be doing?”. Maybe certain concerns have been overegged. But certainly, the failure of analysts to properly estimate passives’ power is an “oversight [that] implies that something is missing from existing models, and policymakers may want to think twice before making regulatory changes based on them”. A fair point – to introduce solutions to complex market problems, policymakers need to actually understand what they are dealing with.

The paper also leads to a more practical question to ponder for investors. Given the frankly astonishing market penetration suggested by the research, and chunky passive inflows this year, could the approach be heading towards a saturation point? This is an especially pertinent thought in the middle of this bear market, when share prices are down heavily left, right and centre, and to be a passive investor means guaranteeing a portfolio in the red.

Active managers are hardly covering themselves in glory. Morningstar’s latest active passive barometer report found that only 40 per cent of active funds in its analysis did better than their passive counterparts in the year to June, down from 47 per cent the year before. Saying that, now is as good a time as any for investors to be focused on outperformance. Knowing where to look is, as always, the hard part. Certain defensive segments have bucked the market this year, with British American Tobacco (BATS) and Imperial Brands (IMB) up by a fifth and 30 per cent respectively. But the sin stock debate is a whole other kettle of fish.