Passive investors: free-riders on the financial market?
There’s no doubt that passive investments have worked very well since the financial crisis and increased their market share. So why not continue with this winning strategy? Again and again we hear warnings that too high a proportion of passive investors has a negative impact on the stability of the financial system. But to date we have seen very little evidence of that.
Indexed investments spell neither the salvation nor the doom of the financial market. This article seeks to contribute an objective view of the subject by presenting a new and differentiated view of the whole system. Markets are very effective in aggregating and processing information from individual market participants. In the financial markets, a distinction is made between active and passive investors. Active investors analyse shares in a variety of ways and place buy or sell orders accordingly. The resulting market price is a product of all these analyses. The accuracy of the judgements of individual market participants may well vary, but as long as the individual mistakes are independent, there is a good chance that their influences will balance out and a core of truth will remain.
For a market to function efficiently, it needs as many independent market participants as possible. Interestingly, the quality of their analyses is not so important for the market as a whole - the main thing is that they contain something of the core of truth.
Sufficient independent active market participants
So what do passive investors do? Ideally, they invest in what is termed a market portfolio: the average portfolio of all market participants. This portfolio contains all the analyses of active market participants. The portfolio simply imitates the market, without compensating active investors for it, or contributing to the market with its own analysis or information. This also explains the low costs of passive instruments. Passive investors - as the name implies - do not actively participate in the market. But as long as there are enough independent active market participants, this does not pose a problem for the market per se.
On the question of how many is ‘enough’, there are many different opinions. But there are functioning markets, for example the Hamburg-Altona fish market, with fewer than 500 participants. So stock markets should be safe for a long time yet. This also explains why the trend for passive investing has until now had little negative impact on the market as a whole. Although the proportion of passive relative to active investors has increased significantly over the last few years, it is still large enough - due in part to the increase in the overall number of market participants. According to the March 2018 BIS Quarterly Review, the global share of passive equity investments more than doubled in the period from 2007 to 2017 from 15% to over 35%.
The weightings of the market portfolio are adjusted automatically - with a few exceptions such as equities being removed or added to the index - without having to place large transactions. So even a large proportion of passive investors will absorb little liquidity in the (still active) market under normal market conditions. So is everything rosy, as the big players in this industry would like to have us believe?
When passive investors become active
In reality, the influence of passive investors is minimal as long as they do not suddenly become active investors. Generally this happens in times of crisis, when investors want to - or have to - cut losses, when private investors throw in the towel and sell after the first market slump. Or if, for example, pension funds have to reduce their equity exposure for regulatory reasons, because otherwise they run the risk of their coverage ratio falling below the statutory minimum. Or when insurance companies have to reduce their exposure to pass their Solvency Test. Then passive investors turn not only into active ones, but unfortunately into active investors who all tend to want to do the same thing. This suddenly absorbs a lot of liquidity and can lead to sudden unexpected big market movements.
Not only that, such market movements can turn even the remaining ‘passive’ investors into ‘active’ investors. We call this self-reinforcing feedback. Anyone who has ever held a microphone too close to a speaker knows the phenomenon. The trend towards passive investments is therefore non-critical for market stability, but not necessarily during an abrupt trend reversal when passive investors suddenly become active.
Simag: the experts
Simag specialises in detecting and investing in self-reinforcing feedback in complex systems. Simag uses technology developed over more than 20 years by the Swiss Federal Institute of Technology. With the help of machine learning, it is possible to construct completely quantitatively diversified active portfolios with attractive outperformance potential.
Every passive investor is advised to question exactly when he or she might become an active investor. It is advantageous for this not to happen simultaneously with numerous other market participants, when it could result in negative consequences. It is also a good precaution to make allocations to appropriate active strategies that have less exposure to ‘crowded trades’ in the market. Free-riders need to be careful not to jump off - or even be shaken off - at the least favourable time.
Moneycab article on Daniel Schmitt's assessment if indexed investments are a danger to the stability of financial markets