'What are the investment implications of passive overtaking active?'

Academic studies on the subject are backward looking, focusing mainly on measuring the passive funds. Very little has been written about where this jockeying for dominance will lead to, but it is increasingly clear that passive will soon be the bigger part of the market.

The future is coming at us fast. The rise of the passives has been aided by the continued sad performance of the actives.

Imagine it like a sine curve, or the rate of change of darkness as we go from summer to winter. The trend towards passives is coming up to the autumn equinox; as it picks up more speed, the underperformance of actives becomes self-fulfilling. What active manager keeps as much as 14 per cent of their portfolio in just Apple and Microsoft?  

US passive funds may do this, and such is the buying power of those funds, that when entering the market to buy more, they may have the capacity to support those share prices.

I discussed this conundrum recently with one of Britain’s finest mathematicians to see if we could get a jump on the quant funds with some complicated new forward predicting algorithms.

Clearly we’re further down the road than we think. The answer for investors? Don’t try to fight the trend.

He considered the problem afresh and said: “The S&P 500 is an algorithm.” And right there, the efficient market hypothesis flies out of the window. If the passives are using an algorithm, we can improve on it. 

Let’s go to the end of the game and work backwards to find an inflection point. Imagine the trend plays out and all funds become passive. All actives have given up, crushed and destroyed by poor relative performance. I know it will not ultimately come to this, but what if?

A note by Sanford Bernstein in 2016 says passive investing allocates capital worse than Marxism, as no one is even trying to decide what is an efficient place to invest. It would seem that we’ve gone from Adam Smith’s 'invisible hand', past the controlling hand of Marxism, to no hand at all.  

Imagine that we end up with all funds being passive. They can only invest by taking account of market cap. No news matters, and so volatility is diminished. This encourages companies to reduce debt levels and sell new equity. The passives’ only concern is the weight of a company’s stock in the index. And so, the big get bigger.  

If through some past cultish behaviour a stock has achieved bigness without immediate merit (that’s two steps forward Amazon and Tesla and one step forward Nvidia), that valuation can hold indefinitely.

In this passive world, if the stock then has bad earnings, it won’t go down. Volatility goes ever lower, only being affected by macro externalities that change fund flows. For example, interest rates become more important as bonds compete with stocks for these flows. 

How far down the road have we already come?

Record weighting by the big stocks has caused a record World Index weighting by the US. Tick.

Record valuation differentials between large-cap growth and cheap smaller companies. Tick.

Diminished volatility as the VIX trends lower over the past few decades. Tick.

Companies, particularly the largest, tending to revert post-earnings shocks. Tick.  

Once you make it big, you’re in the club. A great example is the way meme stocks have held up. Only after nearly three years has GameStop gone back down. It briefly became the largest company in the Russell 2000, issued evermore equity, and its biggest holders became passives.  

Clearly we’re further down the road than we think. The answer for investors? Don’t try to fight the trend. The magnificent seven are not going anywhere soon. However, as their high valuations diminish their future expected returns, we still don’t want them.

The small and value sector, with low ratings not seen since the golden days of the 1970s – and much lower passive involvement – are expected to have better long-run returns because of their extreme cheapness.  

The lines between the two styles of investing will become blurred.

The future will be to create better algorithms than the S&P 500, ones that better allocate capital. That is what investing is.

Smarter exchange-traded funds will incorporate predictive factors such as total shareholder yield, insider buying, high price/sales ratios or momentum. We already use these factors, and more, as we are mindful they are destined to be more important.

Algorithms to uncover intangible predictors, such as good management and trend anticipation, no doubt lie in the wonderful world of artificial intelligence, and have much to offer professional investors and their clients.

As passives use AI to try and predict more human qualities, and actives take on more quant strategies, the lines between the two styles of investing will become blurred.

We are thus led back to thoughtful allocation of capital, which is what active management has always tried to achieve.

Richard de Lisle is manager of VT de Lisle America fund