IS PASSIVE INVESTMENT INFLATING A STOCKMARKET BUBBLE? / THE ECONOMIST

Is passive investment inflating a stockmarket bubble?

A widely circulated working paper suggests so

Illustration: Satoshi Kambayashi

In 2016 researchers at Bernstein, a broker, published a note entitled “The silent road to serfdom: why passive investing is worse than Marxism”. 

A decade later the revolution is still in full swing. 

Trillions of dollars of capital have poured from actively managed investment funds into those that simply track market indices, and the flow shows no sign of stopping. 

As much as 60% of net assets overseen by American equity funds are in such passive vehicles, estimates the Investment Company Institute, an industry group.

Today a note like Bernstein’s, which at the time prompted plenty of headlines and approving references on trading floors, would merely provoke eye-rolling. 

No one is surprised that analysts who sell research to stockpickers dislike the passive funds that are outcompeting their clients. 

Over the years the claims that such funds are bad for markets have tended, similarly, to come from people whose salaries might be higher if they were to disappear. 

Meanwhile, the once-revolutionary creed that motivated the creation of tracker funds has come to feel like common sense. 

What investor does not know that most active managers fail to beat their benchmark index, while the passive alternatives hug theirs closely and charge rock-bottom fees?

None of this, however, means that passive investment really is harmless. 

Its detractors make a valid complaint: markets’ social function is to direct capital to where it will be used most effectively, and passive funds make no attempt to do this. 

Their indiscriminate buying could therefore pull share prices out of whack with underlying earnings. 

Pulling in the opposite direction are the arbitrageurs, such as hedge funds, which can take the other side of tracker funds’ trades and profit from bringing prices back into line with fundamentals. 

Yet a much-discussed working paper—at least among active fund managers—makes a compelling case that the arbitrageurs have a far weaker effect than is commonly thought. 

If so, then flows of assets into passive funds really could be distorting share prices and helping inflate a bubble.

The paper, by Xavier Gabaix of Harvard University and Ralph Koijen of the University of Chicago, sets out their “inelastic-markets hypothesis”. 

This contradicts the textbook argument that money flowing into stocks should barely raise prices, since if it did, demand would fall and return prices close to their starting level. 

In fact, the paper’s authors find that stockmarket demand is not “elastic” in this way. 

It is inelastic, and does not fall much as share prices rise. 

As a result, an investor who buys $1-worth of stocks using fresh cash (or the proceeds from selling other assets such as bonds) pushes up aggregate market value by $3-8.

Messrs Gabaix and Koijen reach this conclusion by analysing “idiosyncratic” flows into stocks between 1993 and 2019. 

These exclude flows explained by other variables (such as news) which might themselves move prices. 

The authors also consider how the structure of markets might make them inelastic. 

For one thing, the arbitrageurs of textbook models are in reality few in number, and heavily constrained. 

Hedge funds hold less than 5% of the value of stocks and face strict risk limits; they must also exit positions when clients withdraw money.

Most important, funds that maintain fixed allocations can push up prices. 

Suppose you exchange cash for new units in a fund promising to keep 80% of its assets in shares. 

The number of shares in existence does not change, but demand for them has risen. 

The fund can buy shares from another type of investor, but in practice flows between investor groups are low. 

(This also implies inelasticity, since if demand were elastic, groups with different beliefs, about future earnings, say, would act differently, boosting trading.) 

The only way to put the cash to work, if all similar funds are to also meet their mandates, is to buy fewer shares at a higher price.

These are just the type of funds into which many people now funnel their savings. 

In 2024, estimates Vanguard, a passive-investment giant, 64% of Americans’ pension-pot contributions went into “target-date” funds. 

These split their portfolios between stocks and bonds in proportions determined by the dates when savers hope to retire rather than by market prices. 

If Messrs Gabaix and Koijen are right, each dollar of this steady flow drives up stockmarket value by several more, regardless of what investors think about firms’ future profits. 

It’s not quite Marxism—but not altogether reassuring, either.