I listened to a fascinating podcast this morning by Grant Williams, it was his episode 3 of "The End Game" series and it was all about the impact of the rise of passive investments, mainly through the eyes of a guy called Michael Green. I recommend listening to it but here are a few takeaways.
Takeaway 1. If you show an active investor a stock on a forward PE of 1x most of them are going to be buyers and if you show them a stock on a forward PE of 40x many of them will be sellers. Thats the way the stock market works right? It is an efficient way of pricing assets. But if you ask a passive investor why they are investing the answer is much simpler. Markets go up over time. So the decision used to be: If I have cash, do I invest it and where and If I need cash what are the overvalued assets I can sell. Now that decision has become; If I have cash, I should invest it, if I need cash I should sell.
Takeaway 2. The implications of this are significant. It appears self fulfilling, if you believe markets just go up then they will. And so the dominant market factor becomes momentum. Over time PE ratios increase.
Takeaway 3. Volatility also goes up and along with it correlation rises. This is a simple consequence of the homogeneity of investments.
Takeaway 4. The market goes up until it doesn't. When the baby boomers reach retirement when they start selling assets to fund retirement then the momentum tips over and there simply isn't the liquidity in the market to halt a collapse in markets when passive funds start to be net sellers.
Thats the summary. My own view is that while there are lots of issues with passive investing in particular when it becomes the dominant investment style it is not a phenomenon that is going away. At present approximately 40% of US equities are held in ETF's, that figure is much much smaller for Australia. The increasing use of passive funds by investors in Australia is inevitable. It is simply a more efficient way to invest for most people. That said we should be wary of increasing volatility and increasing correlation in particular in large price movements. Advisors, Asset allocation and portfolio construction become more important.