The Real Price of Passive: It’s Not the Expense Ratio
Is there a structural flaw in market-cap weighted indexing? Learn why a large index buy has a magnified and cumulative impact on Nvidia (the largest stock) compared to the smallest, how this passive feedback loop is causing massive dispersion in markets, and where advisors and investors should look for opportunities.
Passive investing remains the primary choice of advisors and investors, but is it also the culprit of many of the growing problems in today's markets? Michael Green, Chief Strategist and Portfolio Manager at Simplify Asset Management, delved into the real costs of passive investing for markets and investors with ETF.com's Dave Nadig at the Astoria Macro Summit in October. Below are the main topics discussed as well as their timestamps.
Timestamps
[00:00:24] Passive Investing and Price Distortion- An incremental buy into a cap-weighted index like the S&P 500 will have a disproportionately higher price impact on the largest, most volatile stocks (like Nvidia) compared to the smallest stocks (like CarMax). Green steps through the math and reasoning of why this is.
[00:05:53] The Accumulation of Price Distortion (Selective Cointegration)-The outsized impact that passive investing has on big stocks accumulates over time. This process, which Green terms selective cointegration, is why the market-cap weighted index is increasingly diverging from the S&P equal-weight index.
[00:08:50] The Role of Active vs. Passive Investors- Active managers don't move the market in a unified way, while passive index vehicles amplify market impact. This systemic passive buying contributes to the long-term rise of prices for the largest stocks.
[00:14:15] The Luxury/Veblen Good Effect and Explaining Down Markets- The phenomenon of flow-driven inflation creates upward-sloping demand curves for the biggest companies, meaning the demand increases with price. It’s a trend created when the desire for the item (or stock) drives its value more than its underlying fundamentals.
[00:15:15] Explaining Down Markets- Green explains that the down market of 2022 was partially attributable to systematically rebalanced funds (like target date funds) forced to sell equities to maintain their target allocations as bond prices fell. This net passive selling during rebalancing periods lends credence to the flow-driven price impact theory, with the stocks that led the market up also leading it down.
[00:17:50] Opportunities in Smaller Stocks (Alpha and Risk)- The dispersion of stock returns within the index creates an opportunity to find alpha. However, this is a systemic risk that is unhedgeable, so success often means losing less than the next person, not necessarily a guaranteed positive return.
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