Passive investing has absolutely revolutionized the investment landscape for individual investors. Not only has it dramatically lowered the costs of asset ownership, but it has done so while delivering strong returns. What began as a radical idea to buy the overall market without worrying about picking the winners now accounts for 57% of all equity fund assets and over $13 trillion.
However, with the rapid rise in passive ownership, some investors have begun to sound the alarm. The most recent warning came from Chamath Palihapitiya who stated that retail passive investors would be in for “a rude awakening if this isn’t addressed.” Putting aside the irony of Chamath “caring” about individual investors (after taking advantage of them to the tune of $750 million through his failed SPACs), his critique deserves a fair response.
Palihapitiya is part of a growing group of professional investors calling out the risks of passive investing. And, among them, no one is more vocal than Michael Green. Green, a former hedge fund manager and current Portfolio Manager and Chief Strategist at Simplify, believes that there is a passive bubble waiting to pop. If you want to understand Green’s views in more detail, I recommend reading this great profile on him.
While I won’t go through all of Green’s arguments, the biggest critiques of passive investing essentially boil down to:
- Price Distortion: Passive investing distorts pricing in the market place, causing a momentum effect that makes the biggest stocks even bigger.
- Market Instability: Passive investing leads to more market instability.
- Corporate Governance Issues: Passive investing leads to increased market concentration among fund companies, leading to corporate governance concerns.
I will address each of these points in turn so that we can answer the question: Is there a problem with passive investing?
Problem 1: Price Distortion (Positive Feedback Loops)
The first, and arguably, biggest problem with passive investing is that passive funds purchase shares in companies based on the company’s index weight rather than its fundamentals. As a result, this distorts price discovery and causes the biggest companies (which have a higher weight in the passive indices) to get even bigger with time.
In other words, the relentless bid of 401(k) money going into passive funds every paycheck created the Magnificent 7, not the performance of the underlying companies.
Formally, this is known as a positive feedback loop, which I like to think of as the ancient symbol ouroboros (a snake eating its tail):
Visually, it’s the perfect metaphor for how such feedback loops work.
When it comes to passive investing, the positive feedback loop would go something like this:
- A fund buys a stock
- The stock price goes up
- The higher price leads to better returns for the stock/fund
- The improved returns draws in more investors
- More money flows into the fund
- The cycle repeats
There is a great paper called Ponzi Funds that analyzed how these feedback loops work in practice:
Flow-driven trading in these securities causes price pressure, which pushes up the funds’ existing positions resulting in realized returns. We decompose fund returns into a price pressure (self-inflated) and a fundamental component and show that when allocating capital across funds, investors are unable to identify whether realized returns are self-inflated or fundamental.
Mechanically, the argument makes sense. As more money comes into passive funds to buy stocks, active managers won’t be able to compete with these passive investors to accurately price these stocks. As Michael Green said:
Active managers can’t have enough scale to even stand in front of it, right? It’s like leaning against the steamroller and trying to stop it.
I don’t disagree with this argument, but I’m not sure we are there yet. Though passive investors currently own over 50% of all fund assets, I haven’t seen any evidence that passive ownership by itself has led to higher prices.
After all, if passive ownership led to higher stock prices, then the most passively held stocks should also be the most overvalued, right? But that’s not what we see in the data.
As Eric Balchunas, Senior ETF analyst at Bloomberg, pointed out in September 2024, stocks with higher passive ownership (higher decile) aren’t any more expensive than those with less passive ownership (lower decile):
If we don’t see this impacting valuations, then where are we supposed to see it?
This suggests to me that the issue of positive feedback loops is one of liquidity, and not necessarily passive ownership. As long as there is enough liquidity to set prices, then the impact of passive holding should be relatively minimal. This is exactly what the authors of the Ponzi Funds paper suggested as well:
We provide a simple regulatory reporting measure — fund illiquidity — which captures a fund’s potential for self-inflated returns.
Therefore, more stock liquidity lowers the probability of self-inflated returns (aka the positive feedback loop).
While I agree that passive investing is likely distorting prices somewhere in the market, I doubt this is the case for the Magnificent 7 or the S&P 500 overall. So when Michael Green says that, “It’s not that people are really that blown away by Nvidia. It’s just that half the market doesn’t actually care and won’t sell you shares,” I have to disagree.
Nvidia is a huge, highly liquid stock. While today the indiscriminate buying of passive investors could be keeping its price somewhat elevated, that doesn’t explain how it got to be the 2nd most valuable company in the world. Nvidia didn’t go from $350 billion to $3.5 trillion in two years because of passive investors. Active investors bid up its price as it repeatedly beat earnings forecasts (h/t Michael Batnick):
I am happy to take the L and say that passive investors boost valuations on the margins or in highly illiquid stocks, but to say that the biggest stocks are only big because of passive investing seems very off. While passive investors may one day cause such price distortions for the largest stocks, I don’t see any significant evidence of that today.
But, even if passive investors aren’t necessarily making the biggest companies bigger, they may be making the market less stable overall. Let’s turn to that now.
Problem 2: Market Instability
Another big critique of passive investing is that it creates more market instability. Since passive funds have to buy based on fund flows rather than fundamentals, their behavior could amplify price movements in either direction. For example, during periods of market volatility, if many investors tried to exit their passive funds at once, it could lead to a cascading, negative feedback loop of selling.
This was the basic argument put forth by Michael Burry when he compared index funds to subprime CDOs. Burry used the analogy of a crowded theater with only one exit door. As he stated, “The theater keeps getting more crowded, but the exit door is the same as it always was.”
While I can see why Burry’s argument is correct in theory, it doesn’t seem to hold in practice. If we look at the 2020 How America Invests study by Vanguard, we can see that most passive investors don’t rush for the exit door even when things look the bleakest.
As illustrated in the figure below, only 10% of all Vanguard assets were traded during the first half of 2020 (at the start of the COVID-19 pandemic), compared to 8% in 2019:
Despite one of the most volatile times in market history, most passive investors didn’t do much.
In fact, only 15% of all Vanguard investors made any significant change to their portfolio (where significant is defined as a 10%+ change in their equity position) during this time. You can see this in the table below showing the percentage of investors that increased or decreased their equity allocation by more than 10% during the first half of 2020:
The funniest thing about this table (and against Burry’s argument) is that a subset of investors actually increased their equity allocations as the stock market went into free fall. So while some money was rushing out of the exit door, other money was rushing in.
This data suggests that the fear of a passive-induced negative feedback loop is overblown. Of course, if every passive investor were to exit their funds at once, it would cause a massive meltdown in prices as Burry argues. But, this is true of any asset class. If any group of investors were to start selling an asset class en masse, its price would drop dramatically. Passive vehicles aren’t the issue here.
Negative feedback loops have existed in markets long before passive index funds were invented. Therefore, if this risk ever materializes, I don’t think passive funds will be to blame.
In Burry’s defense though, there is some academic evidence that the rise of passive investing has led to increased market volatility. One study found that, “the rapid growth of passive funds has made stock demand 11% more inelastic, significantly affecting price elasticity in the U.S. stock market.” In other words, passive investing decreased the market’s ability to set prices, making it less efficient.
Some research from the Fed supports this as well. However, that same research found that other kinds of financial risks (such as liquidity transformation and redemption risk from funds) were lower with increased passive investing. So, passive’s overall impact on market stability may not be as clear cut as we originally thought.
While the systemic risks to passive investors during volatile times is likely exaggerated (as the Vanguard data illustrated), increasing passive ownership will likely increase future market volatility. I have no doubt that markets will get less efficient as passive takes more and more share from active. However, this should provide more opportunities for active managers to outperform in the long run. Unfortunately for them, I have seen no evidence of this so far.
Problem 3: Corporate Governance Issues
Lastly, opponents of passive investing have suggested that concentrated ownership of U.S. stocks (via passive funds) have created corporate governance issues. They argue that since these large fundholders vote on behalf of their owners (i.e. individual investors), they end up having an excessive level of control over corporate America. I briefly discussed this when talking about the Vanguard/BlackRock/State Street conspiracy and believe the argument has some merit.
Of all the issues with passive investing, concentrated voting power seems to be the most legitimate. It is true that these firms have an outsized influence on how corporations govern themselves. So, if they want to push climate change or a DEI agenda, they can. It would be hard for any individual investor or any small group of investors to counteract this.
However, in defense of Vanguard, BlackRock, and State Street, I don’t believe most fund owners (aka individual investors) care enough about corporate governance issues to vote on them themselves. As I noted in my previous discussion on the issue, Vanguard voted on over 30,000 management proposals in 2023. Expecting individual investors to spend time on this many proxy votes is neither efficient nor feasible at scale.
While concentrated voting power in America’s largest companies can definitely be an issue, I believe some are trying to do the right thing to solve it. Vanguard, in particular, announced in late 2023 that they were launching an opt-in proxy voting program for some of their funds. And the initial results from the program were promising with over 40,000 Vanguard investors voting their proxies in 2024.
While this doesn’t fully solve the concentrated voting power problem, I believe it’s a strong step in the right direction. We will have to wait and see how this evolves in the coming years.
The Bottom Line (No Good Solutions)
If I had to pass judgement on the most common risks associated with passive investing, here’s what I would say:
- Price Distortion: Not yet, but one day.
- Market Instability: Somewhat.
- Corporate Governance Issues: True, but improving.
Overall, passive investing seems to have caused some minor distortions in markets. However, the bigger problems still seem years away. It’s like what the Michael Green profile said about the super volcano under Yellowstone. We all know it’s a problem, but there’s not much we can do about it for now.
This is the biggest issue I have with critics of passive investing—they don’t have any good solutions to the passive problem. They complain about how market prices are being distorted by passive investors, yet don’t have any way for retail investors to overcome this.
Oh, should I become an active manager? Should I ignore equities altogether? How about I do index rebalancing arbitrage to buy the stocks that are going to get added to an index before they get added?
None of these are realistic options for the vast majority of individual investors. But don’t just take my word for it. Cliff Asness recently went on The Compound and Friends and had an in-depth discussion about this very issue. Cliff’s view is that markets have gotten slightly less efficient and indexing may be somewhat to blame, but the true explanation is likely multi-dimensional (i.e. there are multiple factors at play).
This is probably the answer that’s most likely to be true. Unfortunately, most people don’t want to hear an answer that boils down to—it’s complicated.
Lastly, I have nothing against the anti-passive crowd. They are an important intellectual voice in this debate and I’ve learned a lot from them. However, based on the evidence, I think we won’t see any of their dire predictions come true anytime soon.
Until then, Just Keep Buying and thank you for reading!
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This is post 433. Any code I have related to this post can be found here with the same numbering: https://github.com/nmaggiulli/of-dollars-and-data
