Show this chart to people who blame passive investing for rising stock market concentration
Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
One of the more popular but sillier criticisms of passive investing is that it has inflated a humongous bubble in large US technology stocks, making the equity market more top-heavy and fragile.
Because most major financial benchmarks tracked by index funds are weighted by size, the big just become bigger as index funds are constantly forced to chase performance, bidding up the shares of stocks that are already rising. Or so the narrative-friendly argument goes.
However, this completely ignores the basic mechanics of how a cap-weighted index fund actually works — it doesn’t need to buy more Apple or Nvidia just because they’ve gone up, as it already owns them. So if, say, Nvidia doubles again from here, so does the value of the index fund’s holdings. It doesn’t need to buy a single share to remain perfectly in balance.
Moreover, it is a distraction from what is truly driving things:
This killer chart is from Peter Oppenheimer’s latest Goldman Sachs note on stock market concentration, which Toby Nangle wrote about here.
If Toby’s note whets your appetite, the full note is available outside the GS paywall. The investment bank’s chief global equity strategist has mapped out the multi-dimensional phenomenon of mounting stock market concentration — the rise of US stocks, the rise of tech stocks and the rise of big stocks — and examines the main drivers. It’s interesting stuff.
But as you can see from the above chart, the domination of tech stocks is simply a reflection of an extraordinary secular increase in earnings, further juiced by interest rates falling for much of the past four decades (as long-duration assets, growth stocks do particularly well in falling rate environments).
So please show this chart to anyone who argues that the past decade of tech stock leadership is a figment of passive investing. Index funds are price takers, not price makers.
OK OK, to pre-empt some of the more nuanced objections:
— Yes, for every new dollar that goes into a market-cap index fund, more cents are going into large US tech stocks than ever before. However, the waxing and waning of weightings are not obviously caused or even influenced by index funds.
If the force of passive investing truly was as overwhelming and stultifying as the critics say, the top-heaviness would be semi-permanently baked in the cake. In reality, who happens to be top dog ebbs and flows according to idiosyncratic corporate fundamentals over time.
Just look at Nvidia’s rise over the past year. Its 16.4 per cent jump on Feb 22 alone wasn’t caused by index funds, it was driven by active investors bidding up its shares after another superlative earnings report. Tesla became one of the world’s most valuable companies with negligible index fund buying, as it was long excluded from the most influential indices. Moreover, despite index funds now owning more of the car company than Elon Musk, it’s trading below its S&P 500 index inclusion price.
A decade ago ExxonMobil was still the world’s second-biggest US company, and General Electric, Wells Fargo and Walmart were in the top 10. Today, Walmart is 15th and the others . . . well. On the other hand, in March 2014, Meta was the 17th most valuable company, and Amazon was in 20th place. Nvidia was worth just over $10bn, less than Dr Pepper, Clorox and Tiffany’s.
— Yes, we’re aware of the Inelastic Markets Hypothesis, which proposes that the rise of passive investing has somehow reduced how smoothly the stock market can absorb inflows and outflows.
It’s an intriguing theory that Alphaville plans to dig into properly at some point, but it’s just a theory. The idea that the market has become more “inelastic” for every dollar that has de facto migrated from a closet benchmark-hugger charging 1 per cent into an index fund that charges 0.1 per cent seems implausible. After all, you can torture data into saying almost anything you want.
But it’s at least better than the tech-concentration argument that has floated around for the past decade, impervious to actual evidence and common sense.
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