The rise of passive investing has been one of the biggest shifts in financial markets over the last few decades. Championed by Jack Bogle, it began as an idea that the average investor (and most professionals) couldn’t hope to do better than corporate America, and so the best thing for them to do was to buy as broad a slice of corporate America as possible.
When Bogle was starting out, the conventional wisdom was that savers should pay money managers large fees in order to invest their capital. The conventional wisdom has undergone a seismic shift since then - the average person is now far more likely to buy and hold a stock market ETF that they are to fork over money to a professional who might not even beat the index. Indeed, Warren Buffett (Trades, Portfolio) - probably the greatest active investor ever - famously made a $1 million bet against a hedge fund, arguing that it would underperform the S&P over a ten-year period (he won).
But what effects has the shift towards passive investing had on the market? Has it biased it in some way? At a conference, value investor Howard Marks (Trades, Portfolio) was asked just that. Here’s what he said.
The effect of passive investing on stocks
Marks believes that passive investing and ETF investing does not in and of itself raise the level of the market one way. However, he does think that it can distort the valuation of individual stocks, saying that it "knights" certain stocks as popular and certain stocks as unpopular. If large amounts of money flow into S&P 500 index funds, then that will create huge demand for the stocks that comprise the index and depress the prices of those stocks which are not included. Here’s why that’s problematic, according to Marks:
“With passive investing, nobody ever says “should the money go into that stock?” and “is today’s price fair?” If it’s in the index or in the passive recipe, it goes in, regardless of the merits of the company or the fairness of the price. So clearly, passive and index investing has the potential - and probably has - biased the market in terms of making some stocks higher than they should be, and some stocks lower. If Amazon (AMZN) for example, is held by value ETFs, growth ETFs, high-quality ETFs, and large company ETFs, when people change their mind and want to get out, who's going to buy those stocks?”
The good news for value investors is that this kind of bias creates the mispricings that they should be able to thrive upon. The whole point of value investing is to find stocks that are underpriced due to factors that have nothing to do with their intrinsic value. Popular stocks have always been overvalued, and index ETFs seem to have exacerbated this phenomenon. In the age of the passive investors, those seeking value may be able to find unique opportunities.
Disclosure: The author owns no stocks mentioned.
Read more here:
- Why Can Stocks Jump on Bad News?
- The Problem With Social Trading and Blindly Following
- Why Regulators Shouldn't Close the Stock Market
Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.
