Is Passive Investment Creating a Bubble?
Passive investment by way of index funds or index ETFs is an increasingly popular investment strategy, offering reasonably stable returns while minimising overheads such as commissions and capital gains tax. In 1993, passive funds in the US managed $23 billion of assets, or 0.44% of the US stock market. In 2021, this number had ballooned to $8.4 trillion, or 16% of the US stock market. But what effect does this rapid move towards passive investment have on the broader market landscape?
A paper released earlier this month from the National Bureau of Economic Research suggests that the increasing capital allocation towards passive investment funds gives a disproportionate boost to the market’s largest companies. The paper also suggests that this effect is more pronounced on stocks that the market ‘overvalues’ and has led to increasingly concentrated indexes. The article points out that “During quarters when index funds receive high inflows, the largest firms in the index outperform the index. During the same quarters, index concentration, as measured by, e.g., the combined portfolio weight of the ten largest firms, increases.”
As investors pour money into passive index funds, the money is invested to match the weighting of the existing index constituents. Those stocks with heavier weighting receive the most funds, increasing their market cap proportionally. As these larger stocks balloon, active investors move away from smaller-cap stocks, boosting the large-cap stocks further.
While no specific company names are used, it’s not much of a leap to believe the authors had ‘the magnificent seven’ in mind. The seven, comprised of the megacap tech stocks Alphabet, Amazon, Apple, Meta, Microsoft, NVIDIA, and Tesla, have all seen relentless growth across the post-COVID period. These seven companies now dominate the S&P 500 and the Nasdaq-100 with their movements pushing and pulling the indexes along with them. Seasoned investors have been predicting the end of the seven’s bull run for years now, but the upward momentum remains steadfast.
While I am not predicting some inevitable cataclysm from the disproportionate weighting of these companies, it is an timely reminder of the importance of diversification. A trader solely invested in an index fund may be in for a rude shock if the tides turn against the magnificent seven. This is why our All Weather strategies trade a mix of index funds, commodities, and bonds. The diversification between various assets makes sure the strategy can weather any financial storm.
