In his latest letter to shareholders, Terry Smith explained why passive funds are effectively momentum strategies that create a self-reinforcing cycle, driving up large-cap stocks.
In late 2023, passive investments via index funds surpassed active funds in Assets Under Management (AUM), now exceeding 50%. During the Dotcom boom, only 10% of AUM was in passive funds. While index funds are labeled as “passive,” they are effectively momentum strategies, as their market-cap weighting prioritizes large companies that have performed well.
This creates a self-reinforcing cycle, driving up large-cap stocks. However, an economic downturn, particularly in tech spending or AI, could disrupt this cycle.
If major companies underperform, their declines may hurt index funds more than active managers. Predicting the timing or cause of such a scenario remains challenging.
Here’s an excerpt from the letter:
In late 2023, passive investment via index funds exceeded the amount of assets held in active funds for the first time. They are now more than half of Assets Under Management (‘AUM’). However, during the Dotcom boom, only about 10% of AUM was in passive funds.
As ever, we do not always aid understanding with the labels which we sometimes use in investment. Index funds are not truly a passive strategy. There may be no fund manager taking investment decisions, but such index investing is, in fact, a momentum strategy.
The vast majority of index funds are market capitalisation weighted, like the indices on which they are based. The size of holdings in companies in the index fund is based upon their market value compared with the market value of the index.
So when there are inflows to index funds, the largest portion goes to the largest companies, and vice versa when there are outflows. The result is that as money flows out of active funds and into index funds, as it has been doing, it drives the performance of the largest companies, which are companies whose shares have already performed well, which is how they came to be the largest companies by market value.
This is a self-reinforcing feedback loop which will operate until it doesn’t. For example, were there to be an economic downturn which led to a reduction in tech spending—which is now so large a proportion of overall spending that it cannot be non-cyclical—one area of vulnerability might be spending on AI, as it is not currently generating much revenue.
Were the largest companies then to produce disappointing results, their share prices are likely to react badly, which will drag down the index performance more than that of those active managers who are underweight in these stocks. But even if some scenario like this awaits us in the future, what exactly will cause this and when it may occur is difficult or impossible to predict.
You can read the entire letter here:
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