Tom Bailey: value rally suggests passive flows do not drive market

If the market is driven by investors blindly pouring money into passive market-cap strategies, what caused the value rally?

The past 10 years saw two trends in financial markets and fund flows. 

First, the increased shift towards passive investment strategies. More and more investors became convinced of the arguments for simply buying the whole market, rather than picking their own portfolio stocks or paying a fee to a professional fund managers to try.

Whether investors are attracted by arguments about the efficient market hypothesis or simply lower fees (with both ETFs and index funds now much cheaper than they were a decade ago), the trend is clear. Since 2018, more than half of the money in US equity funds sits in passive strategies. Investors in the UK and Europe have been slower to switch to passive, but are following suit.

The other trend of the 2010s was the dominance of large US tech companies. A handful of big tech companies have seen their share prices surge and now represent an ever-growing share of the market. The five biggest companies in the S&P 500 right now are: Amazon (NASDAQ:AMZN), Apple (NASDAQ:AAPL), Alphabet (NASDAQ:GOOGL), Microsoft (NASDAQ:MSFT) and Facebook (NASDAQ:FB). These five companies account for around 20% of the index. In 2020, this was even higher, reaching around 25%. Taken together, these companies have a market cap higher than the FTSE 100 and a host of other major indices around the world.

There are many explanations for the rise and dominance of these companies. Some point to the phenomenon of the “superstar firm”, in which a handful of outstanding companies come to dominate certain sectors. Some point to their monopolistic position and practices of these companies and the failure of US competition law to address this. Others focus on the impact low interest rates have had on the valuation of growth stocks. The explanation relevant here, however, points the finger towards the rise of passive investing. The first trend is the cause of the second.

Usually, this argument goes something like this. In its most simple sense, passive investing means buying a market-capitalisation -weighted index. Market capitalisation is the number of shares a company has outstanding multiplied by their price. In a market capitalisation weighted index, companies with larger market caps have bigger weightings.

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According to proponents of this theory, this causes a problem. If every investor starts to adopt a passive approach, it means everyone will be funnelling more and more money into the same large companies. For every £1 invested in the US market using passive funds, 20p goes to just five companies.

Historically, in theory, active investors would seek out undervalued or perhaps “quality” companies. There would be a diversity of strategies and money coming into the market would be more evenly spread. But with the rise of passive investing, investors are putting money into the same market cap weighted strategies. As a result, money flows to the largest, most popular stocks simply due to their large market-cap weightings. Today’s winners will continue to become tomorrow’s winners.

But there’s one problem with this theory: it has stopped. It certainly seemed like the market’s winners were carrying on their streak in the 2020, during the height of the pandemic. The tech companies that had flown in value in the 2010s were well suited to the pandemic and the US market became more dominated by big tech than ever. However, all that changed once the end of the pandemic came into sight.

Around last November we started to see a “market rotation”. Thanks to a pick-up in global economic growth expectations, value and cyclical stocks started to outperform. The losers of yesterday, languishing at the bottom of the market-cap-weighted indices, started to rally. Meanwhile, the big tech stocks started to flounder. Oil and banks are now, over this short time period, outperforming e-commerce and social media companies.

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This seems to counter the proposition that the flow of investor money into passive funds drives the market. A change in macroeconomic conditions saw investors favour previously underperforming stocks. The reality is while passive investing has seen immense growth, the market is still full of active stock-pickers. Indeed, as data from Bloomberg Intelligence shows, there is about $6.2 trillion in passive funds in the US. That still accounts for less than a sixth of the total market capitalisation for the US, which stands at $40.4 trillion.

Will passive funds one day dominate the market, causing the sort of potential problems outlined above? Theoretically, I guess. But for an investor looking to maximise their portfolio returns, it is nothing more than an interesting question at this point.

However, another thing to consider with regard to this theory is how the passive investing landscape has changed. Increasingly, ETFs are following niche and specialised strategies. This can be seen in the growth of thematic ETFs. Also popular are ESG products. This can be as simple as excluding certain “sin” stocks, or it can mean a portfolio of companies weighted according to their ESG score in their specific sector. Investors can now chose a variety of different weighting approaches to match their view of the market or their ethical preferences, all allocating money in different ways.

Whatever the wisdom of some of these strategies, to be a passive investor increasingly no longer means tracking a market-cap-weighted index.