What’s being overlooked in the debate about passive investing?

The homogeneity of the active community, that’s what

Passive index tracking represents, by most estimates, roughly 20% of the ownership of large companies in the US. That share has been growing steadily for many years, and seems set to continue to do so.

To adapt the old saying[1]: a trillion dollars here, a trillion dollars there – pretty soon we’ll be talking about real money. So it’s no surprise that there’s been a steady stream of analysis over the years arguing about whether this growth is a good thing or a bad thing. S&P Dow Jones Indices, for example, have recently set out their beliefs for why the growth of passive is nothing to be concerned about. My colleague Liang Yin took a top-down look at the total costs and benefits for society a couple of years ago.

I’m not going to go over the full list of pros and cons here. Rather, I’d like to highlight a couple of points that I think are widely overlooked. The first relates to the nature of the active management community and price formation.

Specifically, one of the concerns that’s expressed about the growth of index tracking is its impact on prices. The price of a security is determined by the balance of supply and demand – so a market price is, in effect, a conviction-weighted average of investors’ opinions about what a security is truly worth. Markets are a means of aggregating opinions. But passive index trackers are neutral in that process; they accept the prices that result from others’ opinions, making no contribution of their own. Hence some observers worry that the effectiveness of the market pricing mechanism could be undermined if too much money simply tracks the index.

But let’s focus on the active management community, rather than the passive, for a moment. If markets are to produce sensible prices, then how much money the active management community is managing is probably not as important as the composition of that community.

It would be a problem, for example, if all active management were to be concentrated in just a handful of huge organisations, each of whom recruit similar individuals from the same educational backgrounds, read the same research, and follow the same global trends in how they invest. As I wrote in a previous post, the more that investors “resemble one another and the more their actions are driven by the same considerations, the more they’ll move in lockstep. And that makes positive feedback loops more likely, and the financial system more fragile.” If there is little diversity of approaches, the market pricing mechanism will be weak, and that’s not the fault of passive management.

How diverse, then, is the active management community? Is its composition becoming more diverse and innovative, or less so?

On the one hand, there are some megafirms out there controlling a huge amount of active money, and some homogenisation of how the largest global investors go about their tasks. But that’s not the whole story. There’s plenty of innovation, too.

Luba Nikulina, who’s been researching active money managers for Willis Towers Watson for 14 years, notes a couple of key trends: there’s more concentration in the largest firms, but also “a significant variety at the smaller end of the spectrum, especially in alternative asset classes.” Encouragingly, she concludes that “the composition of the asset manager community is different than historically but I wouldn’t say that it is less varied.”

Another veteran WTW researcher, Stephen Miles, concurs, but does identify one particular area where diversity is lacking: “there’s not enough true long-term investing”. He points out, too, the destabilising effect of money flows chasing recent performance. If we look only at where new investment mandates are allocated, there’s very little diversity; it just about all goes into the styles and approaches that have performed best recently. This can undermine the effectiveness of the pricing process. And, once again, that’s not really the fault of passive management.

Stewardship, too

Another consideration, which was also largely overlooked for a long time but is now rightly receiving a lot more attention, is that of stewardship.

Even though index tracking is neutral in the price-setting process, there’s no sitting on the sidelines when it comes to stewardship. For example, decisions on whether to vote and how to vote on shareholder resolutions fall on all investors, whatever their approach.

The incentive to devote resources to this aspect of share ownership takes a different form in the case of index trackers than for active managers. Effective stewardship can directly help active managers in their goal of outperforming the market. In contrast, improved corporate performance as a result of effective stewardship does not help index trackers in their goal of matching a market benchmark. That does not, however, mean they have no incentive to take their ownership responsibilities seriously. That’s because client expectations have evolved as the share of the market owned by passive managers has grown. In response to these changing expectations, stewardship is becoming an area of focus and a means of differentiation for passive managers.

A forthcoming Willis Towers Watson paper cites various examples of how the largest passive managers are starting to respond to this challenge. Their actions so far include public advocacy, climate pledges, gender diversity initiatives and corporate engagement. The paper notes, however, that “the commitment so far has been limited and the opportunities to add value seem so significant”. It calls for clearer objectives, and more disclosure of the results of stewardship activity. It identifies scope for more collaboration and more leadership. It notes that “none of the asset managers in our sample has ever filed a shareholder resolution”. Ever. So while there may be momentum and signs of progress among passive managers on the stewardship front, there’s still a long way to go.

If, as seems likely, passive management continues to grow, then the questions of stewardship and the composition of the active management community are likely to attract more attention. In both cases, there are a number of factors driving change. The business context of active management is being transformed by technological advances, evolving societal norms and financial headwinds. The asset manager of tomorrow should not be expected to be a simple continuation of the past. Similarly, changes in the expectations of investors, regulators and society mean there’s no turning back the clock to index tracking being synonymous with passive stewardship. In both of these areas, there’s a lot more change to come in the next few years.



[1] Everett Dirksen, to whom the original quote – which referenced billions rather than trillions – is generally attributed is alleged to have commented "Oh, I never said that. A newspaper fella misquoted me once, and I thought it sounded so good that I never bothered to deny it." Which sounds too good to be true.