Does Passive Investing Distort the Market?

The New Yorker reports on concerns that the growth of index funds may distort the market. Since Jack Bogle introduced the first indexed mutual fund in 1975, their low fees and promise of delivering the market’s outperformance over other investment options over the long term has led to widespread adoption of the strategy. The article notes that “as many as twenty per cent of stocks are now owned by index funds,” and “when you factor in ‘closet indexing’ . . . the proportion of passive investors is higher still.” From 2000 to 2014, the amount of money in index funds quintupled. Noting that “it stands to reason that beyond some threshold, a market that has more passive than active investors will behave differently than markets have in the past,” the article then highlights some recent research on point.

Work co-authored by Jonathan Brogard of the University of Washington “conclude[s] that passive investing sends distorted signals about commodity prices.” The work looked at futures and derivatives markets, particularly their effect on agriculture, energy, and metals companies. As summarized in the New Yorker, the concern is that “the relatively recent entry of passive investors into [futures] markets distorts the demand signal that the price sends, because they’re buying futures without reference to . . . traditional considerations.”

In stocks, the concern is partly that “a market with more passive investors than active ones will continue to push money into the largest firms, whether these companies are actually performing strongly or not.” Timothy O’Neill, global co-head of Goldman Sachs’ investment-management division, said that the tendency of passively invested money to continuously flow to the same places “guarantees that the most valuable company stays the most valuable, and gets more valuable and keeps going up. There’s no valuation or other parameters around that decision.” He thus fears a “bubble machine” that promotes large companies regardless of whether performance improves. The article notes that the market currently relies on active investors to counteract such effects.

Others suggest that the effects of passive investment may more directly harm consumers. For example, the New Yorker piece says, one recent article found that “banks whose shares are often packaged in index funds tend to offer higher fees and rates for such services as account management and deposit certificates,” which may result¬† from a “reduced sense of competition [that] leads banks to charge consumers more.” Harvard law professor Einer Elhauge found similar effects in the airline industry in that index funds are promoting ownership concentration. “Alone, index funds are not enough,” he said, “but they are growing like gangbusters.”

Counteracting these concerns is new territory. Goldman’s O’Neill suggests using factors such as price-to-earnings, rather than sheer market capitalization, to direct indexed fund money could address key concerns. Harvard’s Elhauge points to anti-trust law as an option. In any event, “if passive investment continues to be one of the fastest-growing trends in finance, the concerns will not disappear, and the market may have to adapt to accommodate them.”