Is Passive Investing Destroying the Markets?
This article originally appeared on ETF.COM here.
Passive investing has been ridiculed by Wall Street for decades. The following list is just a small sample of the criticisms I’ve collected over the years:
- Sanford C. Bernstein & Co. strategist Inigo Fraser-Jenkins called it worse than Marxism.
- David Smith, fund manager at Hargreaves Lansdown, called passive investors parasites on the financial system.
- Tim O’Neill, global co-head of Goldman Sachs’ investment management division, warned investors that if passive investing gets too big, the market won't function.
The common theme is that indexing (and passive investing in general) has become such a force that the market’s price discovery function is no longer working properly. Goldman Sachs’ O’Neill has even called passive investing a “potential bubble machine.”
Given the number of questions I get from investors about this issue, one would think that passive investing is now dominating markets. Let’s see if there’s any truth to such beliefs, and whether there’s anything to worry about.
The latest research
A recent study by Vanguard found that, as of October 2017, about $10 trillion was invested in index funds. While a large figure, it represents less than 20% of the global equity market. Is there anyone who thinks the other 80% of assets are handicapped in their price discovery efforts? Even more important is that, while indexing makes up about 20% of invested assets, Vanguard estimated it actually accounts for only about 5% of trading volume. Is passive investing’s 5% share of trading volume setting prices, or is it active management’s 95% share doing so? Once you know the data, you can see how absurd the claims being made are.