The Rise of Passive Investing: Growth, Influence, and Market Risks

The Rise of Passive Investing: Growth, Influence, and Market Risks

The 2024 year-end report of S&P Global Ratings showed that, once again, US passive index funds surpassed around 2/3 of actively managed funds in performance. In 2023, 30 per cent of the money invested in Britain, 29 per cent in Europe, and 52 per cent in the United States were passive investments, as reported by Morningstar. But why do people prefer to sit back instead of actively managing their wealth?

How did passive investments gain popularity?

Passive investments mostly gained attention in the 80s after recovering from a more than decade-long bear market. At the time, the Vanguard 500 Index Fund had $330 million in assets; today, that number surpasses $1.4 trillion. Passive funds have increased in popularity due to their significantly lower costs, usually less than 1 per cent point, and the ease of access for people who do not know much about investing but still wish to make their money worth it. On many occasions, they manage to outperform actual professionals. As Warren Buffet said, "Paradoxically, when 'dumb' money acknowledges its limitations, it ceases to be dumb."

Passive funds aim to replicate fully, partially, or synthetically benchmark portfolios. Exchange-traded funds (ETFs) are the most popular choice for passive investment and offer high returns by mirroring indexes such as the S&P 500 or Nasdaq 100. Examples of well-known ETFs are the Vanguard S&P 500 ETF and the iShares Core S&P 500 ETF (issued by Blackrock).

But despite this form of investing's seemingly golden value, it certainly doesn't come without risks for the market as a whole.

The influence on market dynamics

Carol Geremia, the president of MFS, a Boston-based mutual fund company, has expressed her concerns in an interview with Barron's regarding a rising investment trend, where managers now care more about beating funds' returns rather than making choices for valuable long-term investments in companies. They care about doing it in the smallest amount of time possible. In her "Playing a Bigger Game" whitepaper, Barron also states that Miss Geremia argues that we have lost sight of what the industry market should be doing, which, according to her, is supporting economic prosperity via responsible capital allocation. She believes one of the main causes of this is the too-high expectations of returns, based on the numbers of years ago, which have now clearly changed.

The European Central Bank has also expressed its concerns regarding passive investments, citing market volatility as one of the risks. Because of the mirroring function of passive investments, the simultaneous selling or buying of certain stocks to adjust the index basket based on cash inflows and outflows causes stocks to co-move, which creates a correlation between them and results in higher portfolio volatility. The bank also expressed its concerns about the over-concentration of the market on the same big players, which causes over-reliance on their positive performance.

Stewardship and the Major Players

As millions of people invest in more and more passive funds, their managing companies, such as Vanguard and Blackrock,  also acquire significantly more power and responsibility towards upholding the promises for returns made to their clients. As a result, their voting rights and influence on the biggest companies' management are also becoming stronger. However, history has shown that active investors tend to encourage the business to improve through proxy votes fear, for example, more than passive investors, who lean to agree with management to maintain good dialogue and relationships and whose priorities revolve more around return.

Where does this leave us? Are people investing more while thinking less? Is passive investment a bubble waiting to burst? Are priorities concerning the market changing for the worse?