Will passive investing lead to an inefficient market?

Will passive investing lead to an inefficient market?

Photo by Jezael Melgoza on Unsplash

We sometimes get asked, “if the majority of investors used passive funds wouldn’t this affect the ability of markets to price assets effectively?”.  There might be some validity to this question but what is currently happening in markets and are funds really flowing into passive funds to the extent that this might lead to less efficient markets?

The reasons for using passive funds haven’t changed.  We often talk about the difficulties that go hand in hand with choosing an active – or ‘judgmental’ – fund manager who claims they will deliver market-beating returns.  How do you know who the best managers are in advance and how do you know whether they will continue ‘outperforming’?  Investors trusting their capital to active managers risk an unnecessary transfer of their wealth in the form of high costs and they might also suffer the fate of returns lower than that of the benchmark over the longer term, as evidenced by the track record of many active managers.

Recent history has seen investors transferring their wealth from active funds into typically lower cost index funds.  The funds network group Calastone published data showing the net inflows and outflows for active and index funds.  The data shows that index funds have had strong net inflows since the end of 2018.

This is good news both for investors and the industry as a whole.  Due to the lower cost solutions being used, investors should benefit from a lower cost drag and therefore achieve returns closer to those of the market.  This move also gives the active management industry opportunity and incentive to focus on delivering better value at a lower cost to the end investor.  However, only time will tell the extent to which this becomes a reality.  It is noticeable that after many years of costs increasing, a number of factors have now combined to reduce typical investment costs to levels significantly below what they were when I started my career, even for actively managed funds

Some critics argue that these flows pose risks to price discovery (i.e. stocks being correctly priced).  This leads onto the question I highlighted earlier about the increased use of passive investing potentially leading to less efficient markets.  It’s a truism that if investors continued to move from active to passive indefinitely that market prices would become dislocated from their actual values, as everyone would become a price taker and not a price maker.  However, the reality is that price discovery is a function of the trading volume of active investors (i.e. how much is bought and sold each day) instead of their combined value, and we’re a long way from this phenomenon becoming an issue.[1]

Also, in a situation where market prices are incorrect, opportunities will arise for active managers and other investors to harness these inefficiencies and outperform the markets.  Once this has been observed, money would flood back to those active managers to the point that prices are once again fair.  

Investors do seem to be increasing their use of ‘passive’ investments, but this is unlikely to cause markets to become inefficient in their ability to price assets just yet.  There might also be an increase in money flowing back to a more ‘active’ style of investment management in the future as opinions, trends and maybe evidence change.

At Bloomsbury, we regularly review new evidence that challenges or supports our approach to investing.  The current evidence suggests that focusing on low costs, diversification and capturing market returns gives investors a strong chance of experiencing a successful outcome.  Should the evidence change, we might consider a different approach.

Cheers

Charles

This blog is intended for information purposes only and no action should be taken or refrained from being taken as a consequence without consulting a suitably qualified and regulated person.  Your capital is at risk when investing.  Past performance is not a reliable indicator of future results.

[1] According to Vanguard, indexing represents up to around 5% of daily trading volume (at a push). Vanguard (2018) A drop in the bucket: Indexing’s share of US trading activity, April 2019