Is the Tide Finally Turning in the Active vs. Passive Debate?

In February 2019, the S&P 500 hit a new high, less than two months after one of the worst one-month declines on record. From its December 24, 2018 low, the S&P 500 has gained nearly 20%, brushing off the panic-selling triggered earlier in the month by continued Fed tightening and increasing trade tensions. The latest surge has analysts wondering what keeps fueling this aging bull market, now in its tenth year. According to many market observers, the answer can be found in the constant flows into index funds, which may be driving valuations way beyond intrinsic levels and creating a double-edged sword for passive investors.

Growth of Passive Assets is Entering Uncharted Waters

Driven by their low fees and their apparent ability to consistently outperform actively managed equity funds, index funds and exchange-traded funds have drained more nearly $1.4 trillion from actively managed funds since 2006. According to Morningstar, these passively managed funds now hold 48% of market assets and are expected to surpass 50% sometime in 2019. This would mark a critical juncture for the investment industry, which for decades has built its cachet on its command of stock selection and portfolio construction.

Unquestionably, passive strategies have worked well for investors who question the value of active management when it fails to beat the benchmarks. However, as assets under management (AUM) cross the 50/50 threshold, investors may be entering uncharted waters, which could turn murky for passive investors.

The Double-Edged Sword of Passive Investing

Many market experts believe that, as the bull market enters its late stages, even as fundamental and technical indicators signal otherwise, its continued strength is being attributed in large part to the surge of flows into index funds. At the same time, the massive flows into index funds are distorting market valuations by forcing index fund managers to indiscriminately buy an enormous volume of shares of stocks listed on the index and holding them.

Because the stocks in the major indexes are weighted by market capitalization, the values of larger stocks are lifted much more than the smaller stocks in the index. However, all stocks in the index are boosted by the wholesale purchasing of index shares, including companies with weak growth prospects.

The other very precarious byproduct of massive inflows into index funds is their increasing concentration in the market. Passive managers are now the largest shareholders in at least 40% of U.S. listed companies. This concentration presents new financial risks, including increased investor herding and higher volatility in periods of market instability.

Meanwhile, on the other side of the equation, a 50/50 ratio could effectively remove half the buying power from the market. While active managers search for attractive companies with solid fundamentals, passive investors disregard fundamentals and purchase stocks across the board. During times of panic, when the thundering herd stampedes out of index funds, active managers may not be inclined to buy the entire index of stocks, preferring instead to target stocks they perceive as good values with strong fundamentals. Thus, while active managers seek opportunities in this new risk, passive investors are caught in the vortex of volatility.

Passive Investing Will Work…Until it Doesn’t

While investors have benefited from the massive flows of funds into passive equity funds, they may find themselves on the wrong side when the stock market finally succumbs to the bubble of overvaluation. Overvalued stocks tend to fall harder and faster during a correction. During the recent stock market correction in December, index-stocks fell 7% more than non-index stocks. The disturbing aspect of this is the increasing correlation of index-stocks to non-index stocks in those corrections, which calls into question the advantage of diversification with index funds.

Passive investors have enjoyed a great ride over the last ten years. But it’s time they take note that the stock market has never experienced a prolonged period of average or below average performance since passive investments have approached the 50% AUM level. They should appreciate the unique nature of a 10-year bull market that has led to the dominance of index investing. However, current valuations of some of the larger companies in the market suggest that passive investing may be in for a more challenging environment going forward. It remains to be seen whether the passive “advantage” can hold up under withering fund flows.

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