For decades, we have embraced the rise of passive investing (hammock investing) as the ultimate democratization of the financial markets. The gospel of low costs, broad diversification, and market returns seemed infallible. But while passive assets under management have climbed to astronomical levels, a wave of critical academic research reveals a troubling paradox: the instrument designed to help investors may be structurally distorting the market and ultimately diminishing their wealth.
Two recent papers expose the core of this issue. Together, they paint a picture that should alarm every institutional investor.
The first paper, “Passive Investing and the Rise of Mega-Firms” by Jiang, Vayanos, and Zheng, dismantles the myth of passive neutrality. Their analysis shows convincingly that the massive, non-selective capital flows into index funds disproportionately push up the share prices of the largest companies. When money flows into an S&P500 tracker, it is mechanically allocated based on market capitalization. This creates constant, non-fundamental demand for the “mega stocks.”
This process generates a dangerous “amplification loop”. Rising demand pushes prices higher, which increases the absolute volatility (idiosyncratic risk) of the stock. For active managers, who should serve as the counterparty, it becomes increasingly risky and expensive to go against this flow-driven trend.
The result? The largest stocks can detach from their fundamental value, driven by a force that sustains itself. The authors show empirically that this effect is real in the S&P500 but absent in the S&P600 smallcap index. It is the giants of the economy that “benefit.”
Devil’s dilemma
But what is the net effect for investors themselves? This is where the second paper, “Do Index Funds Benefit Investors?” by Schmalz and Zame, reaches an even more shocking conclusion. Their answer to the question posed in the title is a blunt “maybe not.” They argue that the introduction of index funds creates a devil’s dilemma.
On the one hand, there is the well-known advantage: investors can move from a handful of individual, risky stocks to a diversified basket, reducing their risk and improving their wealth. This is the traditional selling point.
On the other hand, there is a much larger, hidden disadvantage. Index funds do not only attract money that would otherwise sit in individual stocks, but also capital that would otherwise be allocated to safer assets such as bonds. This massive shift of capital into the stock market pushes up the prices of all equities. Higher prices today inevitably mean lower expected returns tomorrow.
Schmalz and Zame’s model shows that this negative price effect can outweigh the positive diversification effect. The result is astonishing: the availability of index funds may reduce the wealth of some, or even all, investors. They compare it to the tragedy of the commons: each individual investor acts rationally by choosing an index fund, but the collective action of millions of investors makes the market (the “common pasture”) more expensive and less fertile for everyone.
Wake-up call
For us as institutional investors, the combined message of these studies is a wake-up call. We operate in a market that has fundamentally changed. The valuations of the largest stocks contain a structural “passive premium” that has little to do with fundamentals. At the same time, returns for all market participants are being eroded by the same passive tide.
This forces us to reconsider our strategies. How do we value companies in a flow-driven market? How do we manage risks when the largest components of our portfolios are subject to these non-fundamental forces? And is there a role for active management to exploit these structural distortions, despite the high risks?
My conclusion is: the era of innocent passive investing is over. The benefits of low costs are real, but the hidden costs in the form of market distortion and reduced future returns are real as well. Ignoring this passive paradox no longer seems like an option.
Gertjan Verdickt is an assistant professor of finance at the University of Auckland and a columnist at Investment Officer.