What will happen to the market if everyone is passively invested? Why do markets need active managers?

Imagine a $1 trillion equity market consistently moving towards passive investing. It reaches the point where 90% ($900 billion) of the investments are passively managed and only 10% ($100 billion) are actively managed. Furthermore, one day, all the actively invested money is withdrawn and instead invested in passive funds. What will happen if everyone decided to go passive? Will the market still function? Does a market need active investors? All of these are important questions concerning the future of the financial markets that we need to explore.

What exactly is passive and active investing?

Active management (aka active investing) refers to a portfolio management strategy in which the manager makes specific investments with the goal of outperforming a given market. The market can consist of US stocks, international bonds, etc. The performance is measured against an investment benchmark index representing the given market. For example, an active US all-cap equity manager will often be compared to the Wilshire 5000 index. By contrast, the purpose of passive investing is to match the market return. In order to accurately match the returns of the US stock market, a passive portfolio holds all the securities in that market in their respective market capitalization weights (aka value-weighted index of all the securities). For example, if Apple’s market capitalization amounts to 2% of the total US stock market, a passive portfolio will have to hold 2% Apple, along with the given proportionate weights of all other constituents. On the other hand, an active investor can, in the two extreme cases, have his/her entire portfolio invested in Apple or not own Apple at all. Notice that any index not value-weighted reflects an active position vis-à-vis the respective market, and any manager not following a value-weighted strategy is an active manager. All the so-called enhanced beta strategies, factors investing, equal-weighted indices, etc., are active strategies. If you watch or read the financial news, you will discover that passive investing is often tangled in with systematic-based investing.

“Passive investing attempts to match the market return; any other strategy is active investing”

Observe that for an active manager to outperform the market, he has to deviate from the market, dictating the need to hold securities in different value-weights and attempting to overweight the ones that will do well and underweight the ones that won’t. The deviations are called active weights, and they can be both negative (underweight) and positive (overweight). Nevertheless, all the active weights sum to zero because for anyone to be overweight a security (compared to the market), someone has to be underweight the same security.

Understanding the inner workings of a market:

It’s important to realize that financial assets are held by someone at all times. There is no such thing as an unowned asset. It thus follows that for every buyer, there has to be a seller and vice versa. What causes the buyers and sellers to trade with each other? What will cause anyone to transact in any market, not just the financial markets? The answer is different valuations/preferences. I have apples but would prefer oranges, and you have oranges but prefer apples, so let’s trade. I have cash from this “overvalued” stock I sold and would like to purchase an “undervalued” stock you own which you think is “overvalued”. What a twister!

Active investors have preferences towards certain securities, sectors, etc. compared to their respective portions of the market (they want more or less of them). Those same preferences are most often arrived at because of perceived mispricing, differences in intrinsic valuations, and/or differences in time horizons. Note, for trades to take place, the active managers’ preferences have to differ. Trading caused by perceived mispricing/valuations establishes the given market values of companies. For instance, if all the active investors suddenly realize that a company is overvalued, they will all begin to sell it and the price will drop to where the market capitalization is close to the active investors’ collectively-perceived new intrinsic value (until buyers and sellers are at equilibrium). In this process, passive portfolios will also reduce their weight to the given security due to its reduced market capitalization relative to other securities. Passive investors’ goals are to match the market, so they copy the assigned relative securities’ weights of the active investors’ communities. To clarify further, the active investors as a whole will decide that Apple should be 2%, Google 3% and so on of the total market capitalization, while the passive investors will just copy those proportionate weights for their portfolio. All the holdings of passive and active investors taken together are what constitutes the market, but only active investors exhibit preferences (they are true buyers and sellers). Hence the quote “passive investors are price takers, active investors are price makers.”

What will happen if the active investors were to go passive?

You can think of this occurring in a number ways. For example, one way would be to just take the money from the active investors and invest it passively, which would mean investing the money using the prevailing market capitalization proportions.  Another way would be for the active managers to simply stop updating their preferences/intrinsic valuations and, instead, keep the assets invested in weights based on current values. In both cases, we can see the repercussions. Liquidity will vanish, as there won’t be anyone trading, since everyone will merely take the last assigned valuations. In the instance of the equity market, there will be no one to update companies’ values even if fundamentals or the macro picture change. Going forward, prices will be stale, since everyone will hold the same relative company values.

“The financial markets cannot exist without active investors, the same way the tomato markets cannot exist without buyers and sellers”

Why we need active managers:

  1. Establish relative valuations of securities: Notice, I am not saying absolute valuations. When active managers determine their preference for securities, their goal is to get as close as possible to what they deem the intrinsic value of a security. They will trade until the market capitalization ratios are thought to be appropriate, meaning securities that are believed to be “inferior” will not have many buyers, and their market capitalization will be lower compared to securities that are considered “superior.” Nevertheless, that does not mean these securities will be properly valued. The active managers control only the relative values of securities, not the total amount of market value. Take the following example: US equity active managers have decided that company XYZ’s intrinsic value is $100 billion, which represents 3% of the total US stock market. Suddenly, many optimistic investors decide to sell $1 trillion in bonds and invest the proceeds in the US equity market. Given this new inflow, what will the active managers do? Their job is to invest the money and, given that relative company valuations have not changed, they will invest the new money in the exact prior comparative weightings. The inflows would not alter the relative intrinsic values, but will alter the absolute values; company XYZ will appreciate to $130 billion ($1 trillion * 3%). The point is that active managers, in a specific market, establish how securities should be valued with respect to each other, but asset class flows determine the total market capitalization and, thus, absolute values.
  2. Provide liquidity: Active investors provide liquidity when updating their valuations/preferences. As mentioned earlier, every existing asset or security is owned by someone. In order for those assets to trade, people will have to assign different valuations to them. For example, if everyone thought that company A is worth $50 billion, there would be no trading. For a trade to occur, one investor has to believe that company A should be valued at $48 billion and another to think that it should be valued at $52 billion. The active investors, via establishing their different “intrinsic” valuations and updating them, provide liquidity to the market.

So, there you have it. A market is a gathering where exchanges take place. For an exchange to take place, differences in values have to exist. The idea applies to every market being it a market for fruits, paintings, financial assets, and so on. If the active investors did not exist with their preferences, the financial markets would not exist.

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