In recent years, US investors have increasingly leaned into a low-fee high-return strategy to fund investment accounts called passive investing. The allure isn't just avoiding the costs of active fund management, it's also the fact that active managers have underperformed the market.

What many investors understand is that if you can't beat the market, you can simply 'buy the market.' This change in market structure has a few consequences.

• A good pool of money is acting as a stabilization force on stock prices; that means higher highs and higher lows.
• It also means a bias for large-capitalization stocks. Walmart is a great example.
• For passive, valuation simply doesn't matter -- value-oriented strategies are guaranteed to underperform.
• Mean reversion -- what Vanguard founder Jack Bogle described as the "iron rule of financial markets" -- has stalled; passive investing has brought what Simplify Asset Management's Michael Green calls "mean expansion."
• When the rate of 401k inflows shrink -- perhaps due to a recession -- passive strategies will be sorely tested.

How passive works

When the chips were down in March 2020, and in 2022 after the Fed rate hikes, and again in April after the tariff announcements, it was the stream of 401k money that helped turn stocks around immediately after initial risks to earnings had faded. That’s led to higher highs and higher lows in the market, as measured by typical valuation metrics.

What’s underpinning the market’s behavior is the growing prevalence of investment strategies designed to track the market itself. The result is overinflated equity valuations that never correct — at least not until there is a major shock.   

Most fund managers can’t beat the market over the long-term, say 5 to 7 years. Heck, they can barely beat the market over a one-year time horizon. Given the fees, you’re better off just ‘buying the market’, aka being passive.

Passive investing is designed to lower costs and approximate overall market returns. Typical retirement 401k accounts do that by allowing workers to put money into target-date and index funds. The goal is to help workers achieve better returns by reducing the fees and underperformance that has been pervasive in actively-managed funds. The strategy also protects unsophisticated investors from the impulse of buying actively-managed funds at their peak and selling them when they are performing worst.

To get a better understanding of how to think about passive, I talked to financial industry veteran Michael Green, a portfolio manager at Simplify Asset Management and one of the leading researchers on the impact of passive investing on returns. One point he likes to make is that ‘passive’ suggests some kind of inertia that has no impact on the market. But think about it for a second. If there’s a constant stream of money ready to buy  ‘the market’ at any price, it effectively behaves as a momentum play, amplifying any upward moves. 

Green says passive acts as an enabling technology where people buy as long as they have jobs. If you are firing traditional managers who help the market adjust and you’re hiring the momentum guys, you have a negative ‘loading’ on value and positive ‘loading’ on momentum.

That’s not a bad diversification strategy if 5% of funds or even 20% were managed this way as we saw in 2010. The reality is that so much money now is in passive funds that it has become the dominant thematic strategy. Bloomberg Intelligence finds that 52%, or $15.4 trillion, of nearly $30 trillion invested in US stocks and bonds markets is passive.

The outperformance of passive is also changing how active fund managers operate too, even in Europe where passive is less dominant. Olivier Nobile of Arkea Asset Management says active investment managers have to adopt hedge fund-style strategies — using more mathematical models, algorithms, derivatives as well as hedging. That leaves less room for purely value-oriented strategies which help put a floor on valuations when equities fall and trigger valuation buy signals as managers like Jeremy Grantham did in 2009.

By the numbers

What about mean reversion though?

Green argues that the mean-reverting nature of equity returns is well-documented in investment research and valuations will eventually decline.

This is the central conceit of a cross-business cycle valuation metric like the Shiller PE, commonly known as the CAPE (the cyclically adjusted price earnings ratio). It is the price of a stock divided by the average of ten years of inflation-adjusted earnings. Green showed me a chart of rolling 10-year nominal returns that looks very similar to the inflation-adjusted ones I’ve been using. The numbers peaked for returns from 2009-2019, with the subsequent returns predicted by the rising Shiller PE suggesting a steep fall in returns, even losses.

I re-ran my decade-long inflation-adjusted S&P 500 returns chart through September and it tracks Green’s chart closely.

(Note: my chart dates look back 10 years to realized returns while Green’s chart shows subsequent returns in order to map the path of returns predicted by the Shiller PE).

Another consequence, as Green puts it, is that the largest capitalization stocks, which make up the biggest share of cap-weighted indexes like the S&P 500, gain disproportionately.

I overlaid a chart of the Russell 2000 on the S&P 500 to make that point clear. Since the peak in shares, the S&P 500 has far outperformed the Russell, whose performance in the last several years is more typical of the reversion to the mean you see after euphoric tops.

Small cap and large cap stocks were rising in concert up until we hit a peak in 2019.  However, once returns started to fall, larger caps took off. The pandemic trading bubble closed the gap almost entirely as everything went up in price. It widened again once the Fed’s rate hikes hit stocks in 2022, and it has never closed since then. This helps explain why Walmart has benefitted so much during this bull market.

This doesn’t mean that valuations will never return to the mean. It just might take longer. After the valuation super cycle top in 1959, decade-long returns in an inflation-adjusted S&P 500 were still near 160% four years later, about 2/3 of the peak. By late 1966, that number was as low as 35% . That’s over 200% lower decade-long returns than the peak seven years earlier, even though a recession didn’t occur until over three years later in December 1969.

This kind of outcome today is less likely without a recession while people are still adding money to their retirement accounts. The risk is that when a downturn does come, the market’s return to the mean will be happening from a much higher level than it would have if smaller adjustments had taken place in the meantime. 

One more thought on passive. If stocks act as a vehicle for momentum because of passive fund flows, then the equity market is more likely to be a lagging signal of recession than a leading one. By the time stocks react to a recession, we could be shocked to find out that it’s already here.

Quote of the week

Things on my radar

• The shutdown raises the potential both for mass layoffs and incomplete data after private payroll processor ADP reported a loss of jobs.
• You might think alternative private data sets can mostly replace US government data. That simply isn’t true.
• Meanwhile it was comforting to see that Federal Reserve Governor Lisa Cook will keep her seat, which means less uncertainty for now.
• OpenAI is now a $500 billion company. Chipmakers added $200 billion in value as the US government shut down.

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