Are too many people passive investing?

27:28So in 1965, companies remained in the S &P 500 for an average of 33 years. In 1990, it fell to 20 years. And the projection is that by 2026, companies will spend 14 years in the index. So they're falling out of the index quicker. How would your research explain that?

27:50Well, actually, I'm not sure that we have something to say about that. I mean, certainly we have, what we can say is that passive is a force that helps the largest firms in the index become even larger. So I think... Do you think the top end will stay there and the other guys... At least it creates a bias for the top end to stay there. I think if the time stating the index has gone down, it's probably because the economy is going through a period of structural change and the kind of sectors that are growing. Interesting. Tech has risen since maybe 2008 tech dominance because of the dot-com bubble.

28:31And there was that period where probably the load fell out of that index then. Yes. You highlight within the research that one of the ways that it helps cement these big companies is through their ability to raise finance for cheaper. Yes. Can you explain that impact and how that works? Of course. So the higher is the stock price of a company, the cheaper it becomes for the company to raise capital because it can raise the... Okay, a company can raise capital by borrowing and maybe the cost of its borrowing, the interest rate has to pay on its bonds, maybe does not go down. But it also can raise capital by issuing new shares.

29:09And if something happens and the company's share prices kind of goes up a lot just because of the price pressure caused by this switch from active to passive. The company, if it wants to raise a fixed amount of money, fixed sum, it can raise it by issuing fewer shares. So it becomes cheaper for the company to, but it does not dilute its shareholders as much. Especially if they feel that they're overvalued internally, they'd be like, well, we might as well issue new shares because, I mean, an extreme example of that was GameStop, right? When the price went up crazy, they just started dumping shares on retail investors because they were like, we can turn what we think is an inflated share price into actual dollars in our bank account.

29:51Absolutely. That's a very good example. And this happens every time that there is some kind of high valuation of firms. I mean, every time. I mean, on average, firms invest more. And sometimes investment, if it's really overvaluation, this investment can be wasteful. Overvaluation is an interesting thing. I highlighted it within the introduction. You say, we study how passive investing affects asset prices, flows into passive funds raised disproportionately the stock price of the economy's largest firms, especially those firms that the market overvalues. And the question I wanted to ask was, how do you know that they're overvalued?

30:27Well, OK, so one thing is kind of theoretically, we can kind of say, OK, here is we build this kind of replica of the world, this model of the world. And essentially, within the model, the overvalued firms are the firms that have a lot of these noise traders, these kind of people who are, for some reason, very excited about the firm. Of course, the question that you're asking is, how can we see in the data, or in the real world, that the market of the company is overvalued? And that's a much harder question. And I don't think that is a question that people spend too much time. I don't know that anyone can convincingly say if a company is overvalued.

31:03Maybe Warren Buffett's got an argument that he's pretty good at it, but it's a very hard thing, isn't it? Because value is subjective. Yes. So, of course, yes. I mean, of course, there are signals and kind of there are various kind of what we call in academia anomalies, trading anomalies and trading strategies that somehow use some notion of overvaluation. For example, there's a very famous kind of anomaly in trading strategy, which is called the value strategy. and there you look at some measures of um of um let's say the company's market the value of the company's market the company market value relative to some kind of accounting measures of the company like a earnings or book or the book value of the company now much of the of this uh kind of variation of that ratio uh kind of why company's market value can be much higher than its accounting value is driven by fundamentals but some of it some part of it maybe 20 percent or so 10 percent can be driven by overvaluation so there are so academics have have measures for these things it's not it's not as it's not a slam dunk it's not that always one of the measures says that the company is overvalued it is overvalued it's also not the case that when this measure is high that you can short sell the company and make money the next day it can be more like a long run from a long-run perspective.

32:20But there are some metrics that are informative, at least are correlated with overvaluation. As markets are quite advanced nowadays, they're quite smart. Isn't everything pretty much priced in? Like Trump does something with tariffs and it's kind of priced in already. So Tesla was like, people said it was overvalued because they made like a fraction of the amount of cars as Ford did. But if it wants to buy Tesla because it's a future, electric cars you know uh robots and stuff so doesn't the market dictate what the price of a company is like it might look overvalued but that's if that's what everyone's willing to pay isn't that just the price like if i sell damien my chain for like two grand and he buys it that's a price someone else would be like two grand then well it's worth two grand but yeah but like someone could say that's overvalued but whatever someone's willing to pay isn't that the value of the and the whole market said testers should be worth this much is it really overvalued or is that the price that we've decided.

33:13That's interesting. Okay. So, I mean, I guess another way to ask the question is more like about whether future returns are predictable. In other words, indeed, maybe people are willing to trade the company at this particular price, and that's the price, as you said. But maybe there are some signals about the company, including the price that can statistically predict the future returns of the company maybe over maybe not over the next month but maybe over the next i don't know year or the next few years and so if we can predict these returns then there might be some kind of mispricing in the market now a big part of research in academia is about seeing whether these returns can be predictable And not only that, but also whether this predictability of returns reflects some real risk of the companies that investors are kind of irrationally compensated for, or whether it reflects kind of some misvaluation.

34:15What I would grant you is that markets are efficient to a significant extent. It's not that mispricing is kind of obvious and blatant, but if one looks at the data kind of in various ways, there can be some signals. but at the same time you can have all of this data and make your prediction and then elon must does something like a nazi salute and then the price of tester crashes so i think like 20 years ago this wasn't quite such a big problem because the world wasn't so connected we didn't have news and social media but now a whole company stock price can change just because of one person's tweet or one person's action so even if you do all your data and then elon wakes up he's like today i'm decide that like i'm a nazi then it all shit gotta change the model yeah the whole model because of one part or donald trump tweets something the whole model changes just because of tariffs or this so is any prediction really like um reliable in in this day's and age when everything changes so quickly look of course i mean every prediction has has noise and every kind of always things can happen that are unanticipated and random and this way i emphasize that some of these signals are kind of very much for a long-term perspective yeah so what do you think the outcome is of these large companies in the index what is that doing to to the market and what's the risk to passive investors i think if you ask me about um from the from the viewpoint of a retail investor i would say that um going going passive instead of investing in a kind of small and diversified portfolio i think would be a good thing to do that's a relief yes oh wealth is in that strategy.

35:55Yeah, yeah. So that's nice. We can end it there. Job done. Thank you for coming on the podcast. Appreciate you. No, no. I mean, yeah, it's good. You think it's a sensible approach? I think it's a sensible approach. I mean, I would for sure not tell a retail investor to hold, I don't know, like three or five stocks. I would say, or even to put a lot of money into active funds. I would say that it's better to hold a low-cost passive fund. And if you ask me what I'm doing, most of my investment is into low-cost passive funds. The point that we're making in our research is that this big switch from active into passive, which is happening for a good reason, for a reason that passive is what we discussed, it's cheaper and everything, can cause markets to become more distorted because there are fewer of these active people who are going to do the price discovery, collect the information, and correct mispricings.

36:51But if, and perhaps, I don't know, if someone was, I don't know, if I were advising, talking to a sovereign wealth fund or to a large pension fund, I would say, yes, maybe you should think more about putting some money into active and let's discuss kind of what active kind of you should do. But if I were talking to a retail investor, I would say that, no, you don't have time to do that. Just you should focus on simple passive investments. It's funny that the thing that was designed to save the retail investors is being spoiled by the active guys. But, you know, is this not like a thing that the active market is always going to say?

37:26It's kind of, you know, or that thing you're doing over there that's saving you loads of fees that we used to collect. That's really bad for you. You know, it's going to break the market. It's kind of like we've had a lot of people there that are active fans that have said that kind of thing. And yet every year passive beats them, you know. Yeah. Yeah, I mean, I guess it's true that the active investors may find this argument kind of plausible and appealing, rather.

37:58But at the same time, I mean, there is something to be said. I mean, the more passive there is, as we said before, the more kind of attractivity becomes to be active. Eventually, if everybody goes passive, kind of it would be big returns to be active. And also the other thing to notice is that, let's say, for example, that money goes from, a lot of money goes from active into passive. So what's going to happen? So from the point, let's say that we think of the point of view of an active manager who has, who invests kind of in a very kind of long-term fundamentals kind of way. And this person identifies these companies that they are, for some reason, they are overlooked by the market, they are undervalued.

38:38Now, if money goes from active into passive, what's going to happen? then this active investor and a few others who are holding these companies are going to lose funds and they're going to go into passive so these companies are going to become even cheaper and these active this kind of sophisticated active investors are going to to to have low returns and they will see this they will see that the kind of companies that they they think that are kind of cheap become even cheaper so they would they would say we see that kind of the market becomes more mispriced. And our job, which is to correct these mispricings, is going to become even harder now because we are losing all this money.

39:13Maybe for a new active investor who comes in fresh, they will see bigger opportunities. But for these people who have already these positions, they will lose money in the transition period. Yeah. I mean, I've heard people say the UK market is cheap for a long, long time, and it just continues to remain cheap. And it's like they're just dying on that hill. And I've heard people say the American market is expensive, the Shilla the cape and all of this and they hold up all these stats and then year after year it's like if you've sat out of that market you've you've lost big in that sense so yeah what do you think about the passive people who aren't so passive so for example they might invest in like six different passive funds so like they might have like a s &p 500 then a world fund like a global fund a global index tracker then they might have ai passive fund like this is your portfolio This guy knows me well.

40:05Do you think they make changes, do you think they still count as passive or are they kind of passive active? Yeah, that's interesting. That's a bit of a gray area in some sense because, first of all, there are some passive, some funds that kind of say that they're passive, which follow an index that is defined with some not very kind of somewhat vague criteria. so they say for example a manager can say i'm a passive fund i follow an ai index how you do how what is this ai index okay i define where the ai index is and i will kind of put whatever stocks i think that belong there okay so that looks very much like active by the same logic kind of an investor who moves across different active funds let's say for example between let's say this kind of playing let's say the s &p 500 let's say global index a european index an asian index and then moves across those also is doing an active asset allocation so um yeah i would i would classify this as as active maybe not the active of in the style of holding i don't know five stocks yeah but they're still active and making decisions and changing things yes what do you think the ultimate threat is if we continue down this route of say like if just as a thought experiment everyone can probably see my little my little leg now you lucky source says that's my knee people be like he's got legs because they never see my legs they only see from the waist up um anyway sorry what let's say the market became 100 passive uh what would that do to the market, do you think?

41:44Well, what it would do is that I think there would be much more volatility. If, let's say, for some reason, for any reason, someone who held a big, let's say, some stake in one company had to get out of the company, there would be nobody who would be able to take the other side of that trade. Passive funds would have to buy the portfolio of all the companies together. So then we would see, for individual stocks, we would see much more volatility. And more mispricing, essentially bigger deviations between prices and their fundamental value, whatever that is. Why would we see more volatility? Wouldn't we just see the S &P 500 on the day that the market became 100 % would just stay as is forever?

42:24Because it'd be like, well, 5 % forever goes to Apple now. Do you know what I mean? You mean, okay, so you're saying, okay, I'm just trying to conceptualize this situation. So you're saying that everybody would be active. No, everyone passive. There'd be no price discovery anymore, right? So we just have a wall of money flowing into the index as is. I see. So in companies, every company would be traded, would be held, all its shares, 100 % of its shares would be held by passive. Yeah. I guess, okay, fine. This is, okay, fine. Maybe this is a bit hard to conceptualize for me because still some shares have to be held by the employees or by the managers or by some controlling shareholders.

43:04But in any case, so I don't think we can get to the - It's impossible to get - It's impossible. But theoretically, okay, let's think of it theoretically. It's interesting still to think through it. So if this work could happen, then, okay, so prices would be completely uninformative because who is going to follow the companies and kind of see if, for example, the company has exciting future prospects, how is this going to be reflected into the price? Effectively, nobody would be trading these companies. Yeah. So they would just, on the day that it happened, we would never move from that. every company would just stay right where it is.

43:39Exactly. Exactly. There would be nothing that would make things move. Okay. So is there a point percentage-wise where you think passive becomes a danger to that? Obviously, 100 % is impossible, but at 80 % passive, which we could get to if we're seeing these, we've grown 10 % in four years, five years, which is crazy, right? Is there a point where the market becomes too passive? Yeah, it's a bit hard for me to venture into this case. But I would say that I would say 70 % passive probably should still be okay. Above that, I would have to, I think, certainly 90 % I think would be too much. But realistically, do you think we could reach 70%, 80 % passive?

44:23Because human nature, like passive investing isn't really, it's kind of counterintuitive. Everyone's like, I'm smarter than everyone else. I can beat the market. So for 80 % of people to be like, I'm just going to leave it alone, that's not really very realistic with human nature just being like oh i see an opportunity i can beat the market i can pick this i'm smarter than everyone else i think that look i mean we have reached 60 i think that um you're right i take your point about uh about um that kind of is human nature to invest in active um i don't know but uh yeah at the same time we have seen kind of a lot of investing becomes more institutional kind of people invest more now through their pension funds pension funds kind of give them and for good reason they give them choices of kind of well diversified portfolios so i think we would see more growth i think we can i would i would see this kind of going to 70 i could see that going yes i mean it's the wall of money and also as well i would say that generationally my parents are more likely to be active because they have this belief that there's people out there that are smarter than the market but whereas my generation are more likely to be passive and there's probably going to be a large amount of flows down to millennials um and maybe younger through inheritances so you might see a wall of money there shift because if i inherit theirst james's place portfolio i'm going to be like well i'll rip that out and put it into the vanguard fund you know and and so you might see those kind of shifts as well through the generations yeah i think i think so yeah so yeah so to recap i think that we should we'll probably see more growth of a of a passive and the of course there will be the incentives for eventually for kind of there will be more profitability for active investors and there will be some equilibrium where there will be some maybe a bit more passive than we have now and and and the rest will be active and some of this active will be real active kind of sophisticated active.

46:22Rather than from just the investor side of things, can we look at maybe a little bit more broader economy? If these big firms find it easier to raise money and they kind of have this pedestal position, does that make competing with them harder? Does it make innovation harder? Yes, it does. I mean, I think this is an issue, at least if one were to take our findings seriously, that this would give the growth of passive, indeed can give an advantage to the largest firms in the economy, which could potentially lead to these effects that you're mentioning. So, yes, I think we have to think about ways that we can, I don't know, smaller firms can also raise capital.

47:10That's important. Maybe if they're not in those indices or if they are not, yeah. Yeah. So do you think that a large part of the rise in the big tech businesses is because of the rise of passive, not just because these businesses have reshaped the world? yeah that's i mean yeah some part of it we find that what we find in the paper is that if if a firm was in the s &p 500 from for the past 25 years or so then it would have a reason by 30 percent more than the market because of this effect of passive so that's a bit of an upper I mean, I think the tech firms, they have grown up, they have grown more than 30%.

47:55So, but anyway, the passive has contributed to that. Of course, and it's a big if, I said, if a firm was in the past 25 years, because as you said, there's a lot of turnover. So index funds, relatively new. Indexes, not new. There's always been like the index, the list to track. Has there not always been concentration within indexes? I know General Motors was a pretty big part of the index, right? Are we just worried about something that's always been a trend? Yeah, that's a very, very good question. Of course, I mean, index concentration can happen for many things. I mean, we're just, obviously, we're not saying that the passive is the only reason of this driving index concentration.

48:37It could be because of trends in the economy. Sometimes sectors become larger just because there is some change in the kind of, some innovation, some technological innovation in the economy. so um or sometimes some companies are like monopolies big monopolies like they used to be the industry was massive right 70 of the u.s market i think was rail exactly exactly so what the only thing that we're saying is that passive has been contributing to that recently so and um i mean what we do what we look in the data we say okay during quarters or what yeah three-month periods when their flows into passive are much larger than their trend.

49:22During those quarters, the largest firm in the index do significantly better than the rest of the index, the S &P 500. So there seems to be an association. It's not the only driver. Do you think the country could do the same? So America, you know, America at the minute, at the time of recording, who knows what's going on, but there's turmoil there and people are doubting you know america as a brand almost but the markets recover quite quickly do you think this wall of money just going 65 into the american market every month could be supporting them in that sense as well so it's not just the big companies it's the big economy and they have this dominant position that then becomes hard to slip from because everyone passively just pours money into their market i don't know i think it's a bit early to to tell with all these changes that are happening these days but um it's very uncertain i mean it's if you ask me whether it's going to whether america is going to become to be to remain dominant i think that now i would i don't know if six months ago i would say obviously but uh now it's i think it's much more uncertain and the same applies for the dollar and everything it's a big big discussion but uh it might be the the cure to the passive because people might be like hold on a second you know i'm american exceptionalism now is not what i thought it was my index is 65 so i'm just gonna i'm gonna pick up a world x usa to to dial down a bit or whatever yeah i mean i guess maybe you have in mind like a global index that is it that's all that's what i buy i buy a global index but you know i can i can concede that i'm basically in the american market with a little bit a little bit of like entrees on the side so weighted yeah 65p in every pound And then if you go a layer deeper, like 20p in every pound is going to five or 10 companies.

51:11That's right. Exactly. So yeah, it's possible there will be this reallocation that I think, I think there has been such reallocation that we were talking about before between, let's say, within passive funds, but across geographical areas. So maybe that will help. It would be interesting if you study this in 10 years and again, and you go, oh, well, that moment there, money started to move more actively because of the doubt around America. You know, my personal view is I just keep buying the index and... The global one. Yeah, it's always a global index. Yeah. I mean, I know it's America light, right?

51:46But I think you capture the global trend. Because I know that, you know, if I look back over, say, 100 years, there's been times of American underperformance, and typically the world outperforms America in those periods lost decades like 2000 to 2008 you know after the dot-com bubble so yeah that's why i buy globally i think if you're buying a global index you are backing america and i'm not betting against america i'm just willing to take a couple of percentage points potentially shave which i have done as a result of buying globally for the idea that i can sleep at night thinking well i've got a bit of everything and if that goes wrong well we're all screwed anyway you know no no i I think it's a perfectly fine strategy, and this I think is in the spirit of what I was saying before as well, that I think it's, I would say for retail investors, I think it makes perfect sense to be well diversified through a passive.

52:41Are you optimistic about the direction of travel for the markets, or do you think that this paper is a warning to the world that we need to do something different? okay that's a good question let me think a little bit about this okay let me I will say about my view about whether this paper is a warning yeah what this paper says is that we think that kind of the growth of passive can be is a good thing this is what we think because it's kind of a cheaper way to invest and kind of it's good for individual investors it's based on market efficiency we say that it's not always a good thing. I mean, if the growth of passive means that still we can have many investors who kind of do these kind of random things, kind of these noise traders, maybe markets can become more inefficient.

53:34So the growth of passive can be a good thing if there is also more sophistication in general, even by the investor community as a whole. So sometimes there can be conditions under which the growth of passive can result in less efficient markets. I guess this is what this paper says. Yeah, yeah. And, you know, is there anything that, I know you've been cautious to not focus on the individual too much. And I think one of the best things out of the research was this realization that there's a lot of, a lot of the issues are active that are pretending to be passive and stuff. But do you have any takeaways from the research for the individual?

54:09Anything that you think, you know, this is what you should take from this? Maybe it's reassurance about their style of investing or anything that you think that they should do. okay so again i should preface it by as we as i have emphasized that passive can be a sensible way to invest for individuals so now i mean the research says okay that there can be a bias in the market that can cause maybe some of the largest firms to become to become artificially kind of their prices to be pushed up more. So I would say perhaps if in the spirit of this allocation of money that is kind of close to passive, but it's not exactly passive by individuals, maybe that one could maybe emphasize a bit more with a long-corrhizal perspective, of course, in maybe, I don't know, not as much the largest firms in the economy.

55:10We maybe have some indices that are, I don't know, like sometimes medium-sized indices or something. But as long as one still kind of keeps a good diversification. And so maybe this would be an implication. But I would certainly not tell an individual investor to go out and short large firms. No, no, but, you know, have some exposure to the smaller companies in the world if you can. I know the FTSE 250 traditionally does better than the 100, you know, because these are smaller, faster-growing businesses. And I think maybe there's an inclination to that. And I do think a lot of investors buy the index and then they go and buy the five biggest businesses on the planet.

55:45And they think that they're investing, whereas actually they're just parking a lot of chips on these big companies. Exactly. So I would tell them not to do that. Yeah. Yeah. Yeah. Not investment advice. Not investment advice. Don't do that.

56:00That was pretty cool. What do you think about Dimitri Damian? I thought he was, yeah, he was a good guy, a stand-up guy. I like the academics. How did it make you feel about your passive investing philosophy? Honestly, it kind of made me feel even more better. More better? More better. Yeah, but it made me feel good about it because what I took from that was, obviously he said multiple times, he still thinks for the average investor, it's a good outcome. But more importantly, the real issue is the fact that the active guys are going passive because they know... They know it's a way. Yeah, so yeah, I felt pretty good about it.

56:31There was nothing in there that made me think, oh God, the world's going to end. Unless everyone turns passive. Yeah, but even he was like, what are you asking me? 100 % passive? It's pretty much impossible. We just need that price discovery, don't we? Who knows? I think hopefully it's decades away before we have to think about it. We actually put together a free investing in index funds for beginners course as well, which we'll link below in here if we can link it here. Yeah, which I think is a great place for people to start if they want to get involved in that kind of thing and the investment approach that I follow.

57:02It's not investment advice. Never. Nope.

57:09Please remember, this is not financial advice. Like we say a lot on the podcast, investments can fall and rise. In fact, it's pretty much a guarantee. Past performance is no guarantee of future results. So your money is at risk with investing and other fees may apply. As with everything financial, please do your own research. We really encourage that because no one cares more about your money than you. I'm Damo. I'm T. This was an episode of Making Money from Our Company Most. It was filmed and edited by the team at Flow Spire, Jack and Ben. It was produced by Ruth Edwards and brought together by Will Stollerman.

57:39What about Ruth and Toothless a Dog? Yeah, shout out them too.