How passive management growth makes the equity markets more efficient.

“Getting rid of the bad apples will make the apple pie taste better”

A common argument against passive investing is that it will lead to less efficient markets and more mispricings, and in the process it will create more opportunities for active investors. Unfortunately for active managers, that argument is flawed—if not downright false. In this post, we will explore how the growth in passive management will actually make the equity markets more “efficient” and decrease “mispricings.” On top of that, passive investing will make it more unlikely that active investors will outperform.

I recommend reading the previous post (Why active investing cannot outperform passive), where we established that active participants cannot outperform the market, quite simply because the active participants’ allocations among securities are the market allocations. Accordingly, they represent the market as a whole. For every outperforming active investor, there has to be an equal underperforming active investor.

Now, what does it mean for the market to be “efficient?”

“Market efficiency is the degree to which stock prices reflect all available, relevant information.” (Market Efficiency Definition | Investopedia.com)

The prevailing thinking is that active managers help markets achieve efficiency by pricing securities via estimating valuations based on available information. Some investors are better than others in estimating those valuations—e.g., Warren Buffet. Note that the active participants must have diverse valuations of the securities in the market; otherwise, no trades will occur. Trading due to the perceived mispricing/valuations establishes the given relative market values of companies. For example, if more active-participant buyers think that Google is undervalued compared to those who feel it’s overvalued, the price of Google will rise. This is irrelevant for the passive investors because they merely copy the relative valuations established by the active investors’ community.

Knowing this, we can establish that every active manager’s goal is to buy the securities with the highest discount to “intrinsic value,” or simply the security with the biggest discount compared to its future price. The investors who are best at finding the securities with the biggest discount to future price will overweight those securities compared to the market. This, in turn, will drive the given securities’ prices back closer to intrinsic value. Hence, this process makes the security correctly/efficiently priced.

This is great, but for every buyer, there has to be a seller. Hence, all the sellers of an undervalued security have miscalculated its intrinsic value. In turn, those investors will underperform at the benefit of the ones that have produced a better estimation of the securities’ future values.

So, who are the managers most likely to outperform at the expense of others?

  1. The higher skilled managers, who, through either better estimates/valuations or other tactics, will allocate to the securities which will subsequently appreciate.
  2. The lucky managers, who, through pure fortune, will also allocate to the securities which will subsequently appreciate. Regrettably, for the lucky participants, their long-term performance will eventually put them in the underperforming bucket.

Thus, the more skilled or lucky active managers have generated returns which outperform the market only at the expense of the less skilled/unlucky participants.  The next question we need to ask ourselves is, “What will happen to the underperforming active participants as passive investing grows?”

To answer this question, let’s look at a good analogy of how another skilled active competition will evolve in a similar scenario. Steven Thorley, Ph.D., CFA, at Marriott School, BYU provides an excellent simple example that I will abridge:

Imagine you and other people were offered the opportunity to participate in a multi-round basketball free throw shooting competition. Each round you will have two options:

  1. Shoot 10 free throws and get a dollar for each made. (Taking the active approach)
  2. Sit it out and take the average score of the remaining competing participants. (Taking the passive approach)

Notice that, in each case, you are likely to make money (with the active approach, you need to make at least one free throw.)

What will you do?

My guess is you will wonder if you are better than the average free throw shooter. If you are better, you will compete. If you are not very good at free throw shooting, you will sit out and collect the average score.

Let’s assume you are better. In such case, you will compete while several participants who don’t think they can score above the average will sit it out. The first round plays out with the remaining participants. What happens to the average score after the first set of below-average participants drops out? The average increases because now the competition is better. What will happen after the second round? The participants scoring below average will drop out again. In the process the average score will continue to rise along with the completion level.

In summary, thanks to the law of competitive markets:

  1. Weaker players will be forced to drop out—in this case, the participants underperforming the average. These participants represent the unskilled active managers.
  2. The skill of the remaining competitors will continue to increase after each round; as the less skilled drop out, more skilled players remain.

Notice the law of competition holds up in all skilled games. Do you think we will see another person in baseball batting above the .400 mark? Not likely, since the competition in this sport has risen.

With this analogy in mind, let’s answer our pressing question. What will happen with the underperforming managers as passive management becomes more available as an option? They will most likely be displaced, leaving the most skilled managers to compete. Since the skill has improved, so will pricing/valuations but this will lead to even fewer and fewer managers who outperform. The skilled managers will have a harder and harder time finding sellers or buyers who have miscalculated the intrinsic value of securities. Let’s use an investor like Warren Buffett as an example. Has he generated anything close to the outperformance he accomplished in the 60s and 70s? He has barely beaten his index. Do you think this might have occurred because he is now competing with astrophysicists and all kinds of other geniuses?

Below chart shows just that. Excess returns volatility has been steadily decreasing as both the competition has increased and passivily managed assets have replaced the unskilled managers.

To summarize:

The increase in passively managed assets will increase the competition by gradually eliminating the less skilled managers. The higher skill of the competition will lead to more accurate pricing, although there will be less alpha availability due to the higher average skill.

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