The passive-investing juggernaut is picking up speed — and it’s stirring up fresh angst about the dangers posed by the index-tracking boom across Wall Street.
With almost a month still to go in 2024, index funds have raked in some $500 billion in fresh cash, while their active counterparts are set for outflows. In recent weeks, that growing dominance prompted outcry from active manager behemoths Apollo Global Management and Citadel, who have blamed the surge in index-following cash for derailing the crucial role of stock pickers as drivers of market efficiency, among other charges.
But two of Wall Street’s largest banks have mounted a fresh defense of the allocation frenzy, which has seen US-listed passive ETFs grab a record $105 billion in the last month alone.
Contrary to popular claims that the price-agnostic money is fueling market distortions by blithely lavishing capital just to the largest companies, a Goldman Sachs Group Inc. study showed the role of fundamentals, like the stability of corporate earnings, remains an all-powerful driver for stock valuations. Meanwhile, passive players hold a far weaker sway, if any.
Similarly at Citigroup Inc., a team led by Scott Chronert found that active managers themselves exert a far bigger influence than their passive rivals on a stock’s performance relative to its industry. It’s a rebuttal to critics like AllianceBernstein’s Inigo Fraser Jenkins, who have alleged that index players are distorting asset prices to a unique degree.
The controversy continues to rage as ETFs, which are dominated by passive products, increase their stranglehold over cost-conscious investors. Passive products now account for 62% of US equity fund assets, up from 35% about a decade ago per Bloomberg Intelligence. In turn, suspicions are only growing that something is off in the underbelly of markets as benchmark-hugging managers become the go-to buyer across the largest indexes.
“The market is not broken, but arguably less efficient,” said Matthew Fine, a value-focused fund manager at Third Avenue Management.
Among passive equity vehicles, ETFs lured $500 billion in the first 11 months of 2024, while mutual funds added $38 billion through October, according to Bloomberg-compiled data. Active counterparts, by contrast, have been hit by total outflows of more than $150 billion.
The passive era is coinciding with an increasingly top-heavy equity market, where the seven largest companies, mostly technology related, keep getting bigger. To some market watchers, it’s proof that the index-fund proliferation is changing the fundamentals of investing, leaving no natural buyer to lift up the equity laggards and close a valuation gap between cheap and expensive stocks that is now among the widest in history. A gauge tracking tech-heavy growth stocks, for instance, has crushed a value benchmark in all but two years since 2012.
In a report by Apollo last month, Felix von Moltke and Torsten Slok pointed to the concentration of so-called “Magnificent Seven” as one unwelcome outcome from the passive fervor, among other alleged aftershocks like higher volatility and lower liquidity.
Goldman, for one, is pushing back. Strategists led by David Kostin found that the Mag Seven overall have lower passive ownership than other S&P 500 members. In other words, indexing money has played a smaller role than expected in the cohort’s dominance. Further, the team showed that fundamental factors, such as earnings-growth expectations and asset turnover, help explain half of the variation in valuations today, while passive ownership has no discernible impact.
At Citi, Chronert and his colleagues compared stock returns against industry peers, and concluded that the differences are more sensitive to active buying than passive. Put another way, despite an expansion in market share, indexing funds remain “tailwinds for, not determinants of” share performance, the strategists wrote.
Discretionary buyers are certainly capable of creating market dislocations in the short term. Super Micro Computer Inc.’s entry into the S&P 500 and Nasdaq 100 this year followed a stock surge that was fueled by AI-enamored day traders and institutional investors — who later saw the shares plunge amid allegations of accounting and governance issues.
Given the stock’s addition into major benchmarks, passive demand may have added fuel to the runup. Still in reality, the line between active and passive is thin because behind each index-tracking strategy, there is a human in every step, writing the investment rules and executing the trades. Super Micro was added to the S&P 500 following a decision by the panel which oversees the benchmark.
The shrinking pool of active mangers continues to fuel fears about market health over the long haul. Those investors play a prime role in ensuring an optimal allocation of capital in the economy by identifying market mispricing, according to Stephen Berger, Citadel’s global head of government and regulatory policy. That role is under-valued by regulators, which “could present a material financial stability risk,” he said on a panel at a recent conference.
It’s a sentiment that finds sympathy with Third Avenue’s Fine, a 25-year market veteran whose $730 million value fund has beaten 98% of its peers in the past five years.
“The whole premise of investing passively is that ‘I’m going to let all those smart people compete against each other, trade against each other. They’re going to create price efficiency, and I’m just going piggyback off of that in economic terms,’” Fine said. “Some portion of the capital must stay with active management.”
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