Making sense of the passive investing bubble

A key characteristic of a bubble is that no one thinks it’s a bubble, says Marc Andreessen, a figurehead in Silicon Valley’s venture capital scene when continuously asked in 2011 and 2015 about soaring tech valuations. If one goes back to 2007 and 1999 - there was no talk about bubbles. It was the opposite - everybody thought they couldn’t lose.

About 6-8 months back, there was a lot of talk about passive investing being a bubble in the US, started by Michael Burry, a hedge fund manager. He correctly predicted the financial crises in 2008. Record sums have flowed into passive funds over the last decade fuelling talks of high valuations on top companies in every index - resulting in polarisation in markets.

Similar talks happened in India - where large pensions funds were deploying thousands of crores into the Nifty 50 resulted in high valuations that were not reflective of on the ground reality. While Nifty 50 was going on a lifetime high over lifetime high - the broader economy was struggling with growth and burgeoning debt problems. So is there merit in the passive bubble argument? Let’s find out.

1. Indexes exist across categories: Indexing does not only involve buying an index of large companies such as the S&P500 or the NASDAQ. There are index funds and ETFs that run across the small-cap, midcap, multi-cap, sector, themes, and various other categories. In reality - there are hundreds of index funds and ETFs managed in all major economies. There are also index funds that buy the entire world economy. There are tactical strategy hedge funds and investors who tend to rotate funds based on valuations and prospects. The only criticism of index funds is that mutual fund wealth gets concentrated (Vanguard and Blackrock), so their influence on proxy voting has got up significantly.

2. Active investing is still significant: Yes, passive funds are over 50% of the mutual fund industry in the US. However, if you look at the entire equity universe - mutual funds are a small part of this. The majority of stocks in the US are held by individuals - not mutual funds, making the US a stock picker’s market. Relevant studies have said that even if you have 10% of the entire market that is held by active investors and traders - they assure prices are efficient.

3. Active investing is very important: Today, most of the trading activity that takes place on the exchanges is via traders, hedge funds, and other large institutions. A reason why a passive fund can purchase and sell millions of shares instantly is due to constant trading activity between traders and other market participants. The stock market does need some active traders who analyse and act on new information so that stocks are efficiently priced and liquid. Active traders thus play a decisive role in the capital allocation process. With high-speed trading via mobile apps, computers, and zero brokerage trading accounts today - active management has never been higher. Index investors essentially are free-riders - they receive the benefits that result from active trading without the costs.

4. Valuations in check: Passive investing in India is nowhere close to where it is in the US. If passive investing led to a bubble in stock prices - it would also lead to a bubble in valuations. But if someone tracks valuations metrics of the S&P500 and NASDAQ indices - valuations are pretty much the same as they were 4,5 even 9 years ago. Earnings (and not valuations) of the top companies have exploded and led to the rapid rise in Index values.

In conclusion - talks about the passive investing bubble may not be relevant in today’s world as there are little evidence and rationale in the argument. Investors, however, should consider valuations before making investments in any equity-based product. A sound asset allocation strategy, combined with periodic rebalancing, is encouraged.