The Impact of Passive Investing: Are We Losing Price Discovery in Markets?

During their recent episode, Taylor, Carlisle, and Brendan Hughes discussed The Impact of Passive Investing: Are We Losing Price Discovery in Markets?. Here’s an excerpt from the episode:

Tobias: Yeah. Then, Microsoft was old economy at that point. So, I do think that it was more of a large growth, and I think we’ve seen more large growth this time around as well. And again, there are some blueberries that are like the interesting things, but it hides the fact that it is still an expensive growth market.

When you look at those long-term averages or the long-term metrics like Buffett’s total market capitalization or you could use Shiller or you could use Tobin’s Q, which is replacement value of assets over market value of assets, all of those sort of seem in varying degrees to point to the same conclusion, that everything is much more expensive than it has been. And I think Cliff Asness had a paper that came out at the end of August, and he said he was looking at the 2000 bubble and the most recent bubble and he said that for all intents and purposes they’re very similar bubbles.

Jake: Like ‘21? Is that what he was saying or right now?

Tobias: I think he was talking about– Yeah, ‘21 is the peak, but the value spread continues to be extremely wide according to his. So, I just wonder, have those metrics lost relevance or are those metrics telling us that we should be humble and there’s something else coming? What do you think?

Brendan: Yeah. I don’t think those metrics have lost relevance. I noted earlier that when you see the US market trading at 200% of GDP, it’s more appropriate to be cautious as opposed to aggressive. But like I also noted, I don’t think it’s a good idea to go 100% cash, then jump back into the market. Because if things do persist, markets continue to go upward, then you might miss those few good–

Now, it’s probably less likely that you’re going to miss one of those epic days from here. But I don’t know, and I don’t think anyone else knows. So, I will say that. But one thing that I don’t think that we have a good understanding of at this juncture that’s playing into this is how passives are playing into this. And I know you’ve touched upon some of the large cap growth. Well, the rally has broadened out a bit recently in US stocks, but it’s still a very concentrated group of stocks at the top. It’s historically concentrated. And I don’t think we understand the element of how passives are playing into this. I think I saw recently that over 50% of ownership in the US stock market is now passives.

Terry Smith of Fundsmith Equity Fund did a very interesting interview recently where he was kind of teasing through as to are we at or approaching the point where markets no longer have a pricing mechanism because of what’s happened with passive investing. I think that’s something really interesting to think about and I don’t know the answer to that, but I think it’s something that people at least need to be aware of and thinking about because where are we in this long curve of increasing passive investments.

Now, 30, 40 years ago, if you went all in on passives, that would have been the right move. I don’t know that is the right move for the next 30 years. I think that a lot of people, a lot more people than they should, are just not even thinking about this and discounting what Terry Smith was teasing through. I think that is something that needs to be thought of because as Terry Smith also alluded to, passive investments in S&P 500 index fund, it’s really an active strategy in that it’s like a momentum strategy. You don’t have a fund manager, but the money is flowing into the largest things that have done the best and that continues to juice the returns of those until that no longer works. I think that this is something that people need to be thinking about, and I know it’s been covered recently in the press.

Tobias: That is one of the things that Cliff touches on in his little note. He said it has some effect, but I think he said he took to, I forget who it was now, but it was like Templeton or someone of that kind of stature, who he asked, someone who was an advocate of passive.

Jake: Bogle probably then.

Tobias: Was it Bogle? Yeah, thanks. Yeah, he talked to Bogle, and he said at what level do you think that there’s too much passive? And Bogle said something like 75%. And he said, “Where’d you get that number from?” And he said, “I just made it up.” I don’t think anybody really knows. I think that his conclusion though was that in a world where everybody goes passive, then it is good to be a factor investor. It’s good to be value and quality and other things like that. And if the characterization of the S&P 500 as being momentum, large cap momentum, I think that’s probably right. We’ve seen plenty of times in the past where that has– In 2000, that strategy came to an end, and it took 15 years for it to recover. Could easily happen again. I don’t know what drives it.

Brendan: I agree.

Jake: Brendan, how did large caps do in Rome 33?

Brendan: [laughs] I’m not sure.

Jake: Oh, okay.

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