“If you are more likely to purchase stocks during periods when the market is rising or tend to sell out of positions during periods of market pessimism, you are probably speculating excessively. The emotional urge to trade based upon the direction of the market has nothing to do with investing or attempting to ascertain the underlying value of a common stock.” - Benjamin Graham
One of the most significant developments in the investment markets in the last 20 years has been the growth of indexed-based investing and the move to passive fund management. Passive investing has grown in popularity among investors, and the recent rise in exchange-traded funds (ETFs) has accelerated the trend. Passive investments now account for 28.5% of assets under management in the U.S. Mutual funds, which track an index, have grown six-fold over the last 17 years while the assets of ETFs have grown 130-fold.
The rapid growth of passive investing warrants greater study of its impact on financial markets, particularly in a downturn or bear market. A recurring argument against indexing is that aggregate or mass movement of funds in and out of the S&P 500, the most commonly followed index, could cause concentration risk, higher price correlation and reduced benefits of diversification. Equity indices weight the stocks they contain by market capitalization. As a result, a few larger companies (such as Alphabet, Amazon, Apple and Facebook) dominate and skew the performance of benchmarks. This weighting effect can be seen when comparing the S&P 500 Index with an equal-weighted S&P index, which removes the large capitalization bias. Year to date, the market cap weighted S&P 500 is up 11.3%, while the equal-weighted index is up 8.1% (as of 8/31/17).
In the pre-passive investing era, a sell-off would entail investors reducing their separate stock positions. Individual investors would own different portfolios of individual stocks and sell different stocks contained in their portfolios, depending on their particular investment parameters. Some stocks would sell off more than others. Conversely in a rising market, there would be uneven performers as some stocks performed better based on the preferences of individual investors.
Contrast this behavior with the new phenomenon of a market with substantial passive investment exposure. A reasonable question is: What is the effect on the value of passive investment vehicles (index funds, ETFs) if a sizable percentage of the total U.S. market moved in lockstep during a rising or falling market? Substantial buying or selling of the same stocks at the same time could exert greater upward or downward pressure on prices, exacerbating highs and lows.
Active management is not exclusively about finding opportunities that translate into outperformance; it is also about managing the downside risk during periods of higher market volatility.
Furthermore, passive investment vehicles, such as index funds, do not consider valuation when buying or selling. With a large number of investment decisions on autopilot, more and more money will be invested with funds whose value is largely independent of factors that have traditionally guided investors, such as profitability, efficiency, competitive threats, management performance, growth potential and broader economic conditions. Passive investment products do not distinguish between the good and the bad. They invest in all of the stocks comprising the index, irrespective of any views about value or quality.