In the context of the recent ups and downs, what’s more interesting than this creeping inefficiency is whether the growth in passive investing is also making markets more volatile than they used to be. Writing on the recent stock market environment in the interim report of Pershing Square, a FTSE 100-listed investment trust, investor Bill Ackman was in no doubt where to point the finger.
Because so much of the market value of companies is now in the hands of permanent value-indifferent owners, he said, the importance of other short-term, often highly leveraged investors in setting the market price is magnified. But there’s more to it than this.
Their heavily geared, in-and-out investment strategies also have no tolerance for even temporary losses. At the first sign of sentiment moving against them, they are therefore out, exacerbating price falls and ramping up volatility as the majority, passive holders are forced to follow suit to maintain their weightings.
The pendulum swing of markets is intensified further by the way in which money flows, both in and out of an index fund, create buy or sell orders for all stocks in the index at the same time. All shares, therefore, move in the same direction at the same time. The benefits of diversification are reduced and systemic market risk increases.
Does this matter? On the one hand, the growing importance of passive funds and the mispricing it naturally creates is good news for an active stock picker. It provides the investment opportunities that a truly efficient market could never do.
Take two high profile examples from the recent market turbulence: Apple and Nvidia were, at their low points, 17pc and 31pc below their most recent peaks. Many investors saw that as a compelling opportunity and Nvidia round-tripped from $135 (£103) to $99 and back to $130 in a month. It was the “fat pitch” that Warren Buffett entreats us to wait for.
The market inefficiencies and volatility that the rise in passive investing is creating are the investor’s friends. To exploit them, however, we need to do two things. First, we need to invest according to real world financial principles and not just market valuation ones.
If a tidal wave of passive money is making markets both less efficient and more volatile, we risk being drowned in our puny attempts to swim against the current. We need to see through the confused messages in the market price and try to identify the fundamental value hiding behind the static. And trust that it will emerge in due course.
Which points to the second key characteristic of a successful investment approach in today’s skewed markets. The last few weeks showed that, in the short term, fundamentals can tell us nothing about where markets are headed. But over a long enough time-horizon, the distortions created by the dominance of passive investing will be ironed out.
It has always been necessary to adopt a long-term approach to equity investing; but in less efficient and more volatile markets it is essential.
Tom Stevenson is an investment director at Fidelity International. The views are his own.
