Passive Investing – “The Market Knows”

As passive investing grows, proactive investing, to shape a future for all of us, recedes.

Finance Watch Passive Investing – “The Market Knows”

Why should we be concerned?

Society should be actively choosing which projects to finance and which activities are important to us, so that we can allocate finance accordingly. Yet there are a wide range of changes to the financial sector which mean this is less and less the case. One such change, especially since the crisis of 2008, is the rise of passive investing, where funds are allocated based on the composition of indices, such as the S&P 500, and not by investors actively choosing what to finance and what not.

The problem is that passive investing means we give up even more decision-making power over what does and doesn’t get financed. That decision now relies increasingly on, first, uncritical acceptance of a certain type of economic modelling (and let’s face it: the models turned out to be very wrong in 2007-8!) It also relies on the obscure parts of the financial sector that compile indices. Researchers are concerned that this trend can lead to self-fulfilling bubbles, which in the long run could be dangerous.

As citizens we should be concerned. For huge swathes of the economy we are not actively directing society’s finance to where we urgently need it most.

The indicator…

According to researchers quoted in the FT, 38% of managed equity assets around the world are now invested in passive funds. In the US, the figure has reached 50%. What is impressive, however, is the growth. Passive investing has received a massive boost since the crisis of 2008. For example, in the USA in 2016, around $340 billion were moved out from actively managed funds, while $ 505 billion flowed into passive vehicles. At that rate, passive investors could control over half of US stock and bond markets by 2021!

Researchers at SPERI at the University of Sheffield also give an idea of this important change “Between 2007 and 2016, actively managed funds in the US recorded outflows of roughly $ 1,200 billion, while index funds received inflows of over $1,400 billion.”

They highlight the critical role of giant asset managers, in particular the ‘Big Three’- Black Rock, Vanguard and State Street. These three dominate passive-investing firms and have “nearly $11trillion assets under management – three times the value of the global hedge fund industry.” This means that, taken together, they control large swathes of the US economy. For example, “in 88% of S&P 500 firms, the Big Three- seen together as one investor block- are the largest shareholder…”

What should we change?

We need to take control of finance, make it a servant not the master. One important way to do that is to actively decide, collectively, where money goes, what gets financed and what not. There are many ways to achieve this but perhaps key will be the promotion of democratic forms of finance, from state finance to cooperative and mutual banks and to public green investment banks. You can find more detailed policy ideas elsewhere on the Finance Watch website and on the Change Finance website.

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