The Passive Investing Bubble: A Terrifying Theory
Why the trend toward low-cost ETFs could be damaging not just the stock market but global economic strength
In this article I’m going to delve into a theory called “the passive investing bubble.” While I’m not as concerned as most proponents of the theory (proponents who include Big Short legend Michael Burry), I do think it’s significant enough to warrant some airtime here. I think every investor should be aware of the theory, whether or not they find it credible.
Let’s start with how we got here. I’ve discussed the distinction between active and passive investing before. Here’s what I said:
Over the last 15 years or so, opinions have shifted sharply on the issue of active versus passive investment management. Almost all investing used to be active: you paid a financial company, who would assign you a broker or salesman. This agent would pick a list of stocks for you to invest in. Or, you would invest with a fund that pooled resources to do the same thing. This model has been largely replaced by passive investing: you invest in a ticker that tracks the S&P 500, or the world’s top tech companies, or something similar.
The problems with active investing were legion: management companies charged fees, which were difficult to overcome even if performance was good. On the average, they failed to beat the benchmark. Some gambled and suffered implosions. When there were downturns, they panicked and sold everything, rather than calmly holding and returning to the mean like a passive fund would do. The replacement of active funds with passive funds has largely been better for investors in terms of both cost and returns. The people who popularized passive investing, such as Vanguard’s Jack Bogle, are generally remembered positively.
The last sentence is what I want to elaborate on in this article. Given we are now solidly in the era of passive investing and history is written by the winners, most of the financial media now holds an unvarnished positive view of the change. The problems with active investing (high cost, risk of underperformance, lack of diversification) are discussed frequently, while issues with passive investing seldom get any airtime.
What could be wrong with passive investing? It just means everyone pools their money and buys index funds. The funds are cheap, diversified, and as safe as can be. But below the surface, there are some serious drawbacks.
It’s led to the rise of BlackRock and other corporate giants
When active investing was in vogue, there were many large financial firms on Wall Street that traded significant numbers of shares in all the major publicly traded corporations in America. So it’s not as if the landscape was dominated by mom-and-pop shops. But the rise of passive investing has directly led to the rise of even bigger giants. BlackRock, Vanguard, and State Street, who are the leaders in the ETF and 401(k) industries, are the largest shareholder in almost 90% of the S&P 500.
This rather shocking statistic is distinct from RFK Jr.’s incorrect campaign trail claim that they own 90% of the S&P—they’re simply the largest shareholder in 90% of the companies. Their actual ownership is probably closer to 1/5. But that’s still a shockingly high percentage, and having that many shares entitles them to significant management influence as well.
It should be noted that BlackRock’s ownership is on behalf of clients. While common, it’s mistaken to think that BlackRock itself owns this much of the country. Individual investors are the ultimate beneficiaries of the ownership, and nominally control the shares. But in practice, this isn’t how it works: the overwhelming majority of investors don’t exercise any of their shareholding powers, so the power gets conglomerated into the hands of BlackRock, Vanguard, and State Street, who then exercise massive influence over the board of directors and management of the top 500 companies in America.
It potentially discourages competition
Respected Bloomberg blogger Matt Levine, among many others, has explored the theory that this conglomerated ownership discourages competition. The example he gives sounds something like the following: imagine you’re the CEO of, I don’t know, Delta Airlines, and you decide to introduce an innovation that will lower prices for consumers. Or a better plane. (I’m still waiting for the Concorde V2, personally.) Something along those lines.
You’re excited to make your change. It’s going to be huge for Delta. But then something strange happens: you get a call from the CEO of BlackRock. He tells you that as the largest shareholder of Delta, he doesn’t approve of your idea. If you do it, he might have you sacked. Why? Because it would actually be bad for BlackRock’s portfolio. If your new innovation takes off, it’ll make money for Delta. But American, United, JetBlue, and Frontier stocks will all go down, since it’ll take business away from them. Those other companies will have to (redundantly) spend money to clone Delta’s idea. Then they’ll have to spend money attracting the customers they’ve lost. Why not just keep things the same, the CEO says? Everybody’s making money. Go against me, he threatens, and I’ll use my influence over the board to see that you lose your job.
There are many more examples you can think of. Companies could coordinate raising prices. They certainly won’t cut prices and start a price war, like they might have in the old days when they actually had separate owners. The concern is that they’re becoming more coordinated, almost cartelized. In the 1950s or 1960s, the era of lifetime employment, this would have been hard to imagine: workers at, say, Ford and GM, disliked each other intensely, and even though the car industry was technically an oligopoly, they competed fiercely.
It’s very important to note at this point that there’s no evidence this has actually happened. There are no reports of BlackRock, Vanguard, and State Street calling CEOs and nixing bold plans. But even though it hasn’t, it could. And the way incentives are set up, it could potentially be a major damper on competition.
Matt Levine explains the situation as follows:
The companies all work for the same owners and are, in some very loose theoretical sense, all divisions of the same universal trust.
Scary thought. This and other concerns even led financial company Alliance Bernstein to publish a lengthy, provocatively titled note saying passive investing could lead to worse economic outcomes than Marxism in 2016.
It might lead to lazy management and lack of innovation
As the above example situation clearly illustrates, passive investing could be a damper on innovation. If the CEO of one of the big three firms mentioned above calls a company CEO and squashes the company’s plans to kneecap its rivals, that’s a very serious problem for capitalism. But beyond that, there’s a more insidious one: the CEO could never make the plans at all.
Why would this occur? It might spring from simply lazy management. If you’re the CEO of a company that’s in a major index like the S&P 500, every single week, money from workers’ 401(k)s is going into your stock, as is money from savers who buy ETFs like SPY. (To explain this process for those who aren’t familiar, the money goes into index funds, which are legally pledged to follow stocks in the index. So without discriminating between index components, they buy all the stocks in the index on a regular basis.) This is the kind of consistent tailwind that can make even an ambitious executive fall asleep at the wheel. It’s hard to have the kind of bloodlust that you need to take down your competitors when your stock is rising 20% a year and part of that money is being deposited directly into your bank account via options and restricted stock.
As the term suggests, it might be leading to a massive bubble
I’ve done everything so far but explain how passive investing could also be a bubble. Socially damaging, yes, but a bubble? The bubble theory springs from another problem with passive investing: instead of each stock following a radically different trajectory, everything goes up or down at the same time. Inflows and outflows are general to the market, not specific stocks. (Of course, this isn’t entirely true, since individual stocks can still fall or rise outside of trend, but asset price correlations have grown significantly in the past couple of decades.)
What that means is that there’s a real case (though it’s hotly debated) that price discovery in the market is broken. What that means is that if a company stops innovating, starts making bad products, alienates its consumers, etc., those problems might not be reflected in the price immediately, or at all. The mechanism of prices falling as soon as business starts to decline was key to discovering problems in the market. Now that everything is going up at the same time, it’s very difficult to tell if individual stocks are massively overvalued. Even if shorters publish a damning case against a specific company, they may struggle to get the price adjustment they’re looking for if ETF and 401(k) inflows continue to inflate the value of every stock.
What I’ve just outlined in this article is a very exaggerated picture of our current investing world. I want to emphasize that BlackRock is not actually calling CEOs to crush innovation, and that not every single stock in the market rises or falls at the same time. But despite the artistic license, the overall point behind each of these concerns is still very valid. There are no clear solutions on the horizon, and these drawbacks to a system that has been very consumer-friendly are something everyone should be aware of.