When you stick a cold thermometer into a warm glass of water you get a reading of the water temperature, but that measurement will be slightly cooler than what it was before you stuck that thermometer in. This “observer effect” applies to countless physical and social phenomenon: measuring an electrical current creates resistance, which changes the current; informing your staff that you will now be observing their start time every day will probably affect what time they turn up.
And now, in a multi-trillion-dollar global experiment, the observer effect has arrived at the heart of finance: welcome to passive investing.
The Role of Passive Investing
In my podcast with Phil Muscatello on “Shares for Beginners”, I discuss that the role of a financial index has traditionally been as a measuring tool. For equity indices, the aim was to measure market performance and sector weights. These measurements could be used for benchmarking fund manager performance as well as general market insights. Then, an epiphany struck the investment world: a stock index turns into a pretty good portfolio. It will not outperform the market, but it won’t underperform either. Combined with low fees that come with simply tracking an index, passive investing boomed.
There have always been concerns about how big passive investing could get before it began to influence the markets. Everyone agrees that, logically, passive funds cannot make up 100% of the share market. Price discovery requires some active players in the market to trade and discover prices. When passive hit 10% of the US share market, few were concerned. Same at 20%. By the time it was 30%, a few participants were starting to take note of the effects it may be having. Today, the US market is 43% passive.
This money has mostly flowed into large, broad, market-capitalisation based index funds. However, the success of passive investing has spurred the creation of a vast range of new indices: Thematics (robots, anyone? Or how about a technology index?) and more technical “factor based” indices (Minimum Volatility, Quality, Value, etc). Many of these indices have been specifically designed as portfolio trackers rather than as pure measurement tools.
Another issue is that while many of the indices are designed to capture different segments of the market, they often hold many of the same stocks. For example, an investor may want some broad US market exposure through the S&P 500. The top holdings are Apple, Microsoft, Amazon, Facebook and Google (Alphabet).
The investor may then like some technology exposure and therefore buy a Nasdaq 100 ETF. The top holdings are Apple, Microsoft, Amazon, Facebook and Google.
Then, seeking some international exposure, an investor may buy an ETF tracking the MSCI World index. The top holdings are Apple, Microsoft, Amazon, Facebook and Google.
Finally, the investor may like to hold an ETF tracking the MSCI World Quality index. The top two holdings are Apple and Microsoft.
Circularity of measuring
With so much money flowing into passive funds and with many of those funds holding lots of the same names, the indices that were designed to measure the market have switched to becoming active players in the market. The circularity of measuring the market with indices that are tracked by almost half the market in the US has started to lead to funky outcomes, such as the recent shenanigans with Tesla.
The observer effect is a well-known phenomenon, but its impact on the share market via passive investing is brand new, little understood, and happening right now. Buckle up because the funky stuff has only just begun.
This article and podcast is part four of a series written by Tamas Calderwood on the risks of investing in the index. Read parts one to three here.
- Tesla, the S&P and Passive investing
- Tesla and the soft dictatorship of the index
- Passive is massive, so Tesla got dumped