The relentless rise of passive investing

The Relentless Rise of Passive Investing

Several prominent markets commentators, including financial journalist John Authers and hedge fund manager David Einhorn have recently published insightful pieces about passive investing [1]. Both of them contextualised the extent to which the investment landscape has changed in the last two decades and in particular the way in which investors access the stock market. 

In late 2023 the amount of money managed in the United States on a passive basis exceeded that managed actively for the first time [2]. Readers will recall that to invest passively in a market weighted (number of shares in issue multiplied by share price) equity index is to allocate each Pound, Dollar, or Euro in proportion to the relative weight of each share in the index. The index represents the market. 

Each index reflects the relative success of the stocks in it. For example, Apple is one of the world’s most valuable businesses because it created a revolutionary device and an inescapable ecosystem (see later). Therefore, in the MSCI World Index it is a large component. 

Contrast this approach with an active investor who analyses various businesses on their specific merits and then invests via the purchase of their respective shares. This investor will typically have a portfolio that is different from the market as represented by the index [3]. The degree to which they are different is called the ‘active share’. 

As the amount of money invested passively begins to rise, and it seems reasonable to assume that it will, what will the implications for the portfolios we manage and markets in general be. 

The platform business model and passive investment 

In the years following the Global Financial Crisis a specific type of business strategy has become preeminent and it relies on something called the platform business model. The platform business model takes advantage of the network effect such that as the number of users engaging with it increases so does its economic value. Imagine Facebook with only a few hundred users. It just wouldn’t be very appealing in a purely financial sense. 

As far back as 2015 Microsoft CEO Satya Nadella told the investment community that their strategic plan was to create a software platform [4]. One only need look at the performance of Microsoft shares since then to see that this has been a resounding success. Software, and in particular the internet, is the technology that has enabled the platforms which Amazon, Apple, Microsoft, Alphabet and Meta have built. 

Let us return to the example of Apple, in order to demonstrate the power of this. Apple started life as a hardware manufacturer. Granted, they were exceptionally good at this but producing a blockbuster product year in year out is tough. What they did have, and in fact still have, was a loyal and growing fanbase using their devices. Why not use apps (software) to sell entertainment and news content via subscription. The acquisition cost of each new user is effectively zero because they have chosen to buy the device already and the more people that sign up the better. 

Upon reflection it is therefore not surprising that these businesses have become such a significant part of the investment landscape. The top ten stocks (incl. all of the five above) in the MSCI World Index [5] now represent 18% of the total global equity market value, the US is 63% of that total and there are 2,900 stocks in the index itself. Once one moves outside the top ten the proportion allocated to even relatively big and successful businesses begins to fall quite rapidly.

Diversification: Good businesses vs Good Investments 

Effective portfolio diversification is the cardinal lesson that keeps having to be relearnt in every market cycle. There is no question that the handful of US companies mentioned earlier are fantastic businesses, but there is a difference between a good business and a good investment. 

As the passive wave reaches a crescendo there is a danger that the concentration in a handful of stocks begins to intensify far beyond what the fundamentals warrant. Throw in the justifiable excitement about AI and you have passive flows interacting with active flows chasing the same businesses. This is the very definition of a financial bubble. What started out as healthy market innovation might metastasise into something quite dangerous.  

We are not in the business of prediction, but it is prudent to think carefully about might happen and to remember to diversify effectively.  

[1] https://www.bloomberg.com/opinion/articles/2024-02-16/passive-investing-resistance-round-ii-where-price-discovery-survives?leadSource=uverify%20wall

[2] https://www.bloomberg.com/news/audio/2024-02-08/masters-in-business-david-einhorn-podcast

[3] We are not making a judgement on the relative merits of each approach. This debate has been settled. Passive investing is a useful investment tool.

[4] https://www.forbes.com/sites/adrianbridgwater/2015/04/29/how-microsoft-office-became-a-whole-computing-platform/?sh=2f1b645c3e4a

[5] https://www.msci.com/documents/10199/8d97d244-4685-4200-a24c-3e2942e3adeb

Disclaimer: This communication is issued and approved by Whitman Asset Management Limited (“Whitman”) which is Authorised and Regulated by the Financial Conduct Authority. The value of investments may fall as well as rise and your capital is at risk. The information does not constitute financial advice or recommendation and should not be considered as such. Conduct your own research and seek independent financial advice when required.
Although Whitman uses all reasonable skill and care in compiling this report, no warranty is given as to its accuracy or completeness. The opinions expressed accurately reflect the views of Whitman at the date of this document based on our views at such time regarding market conditions and other factors, may depend upon assumptions or projections that may not prove to be correct, and are subject to change. The opinions stated are honestly held, they are not guarantees and should not be relied upon.

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