MDUDUZI LUTHULI: Markets intact despite rising passive investing

The rise of passive investing has sparked intense debate about its effect on markets. Some argue it is a positive development for investors, while others claim it has “broken” the markets. So, which perspective is correct?   

Passive investing’s growth has been a boon for investors. By tracking market indices passive funds offer broad diversification and lower fees. This shift has forced active managers to rethink their approach, and investors have benefited from increased transparency, reduced costs and simplified investment decisions.

However, concerns surround the potential implications of passive investing on market behaviour. One of these is that passive funds might alter market behaviour by detaching prices from fundamental values. Since passive investors don’t actively evaluate companies, prices may reflect flow and liquidity rather than business fundamentals.

This raises questions about market efficiency and the role of active investors. Is there such a thing as an efficient market? And if there is, for markets to function efficiently do we not need active investors analysing companies and setting prices? Do passive funds rely on active investors’ research to function?

It is difficult to conclusively answer any of these questions. To further complicate matters one can rightfully ask, “Are all active investors trying to find fair value?” The answer is absolutely not. Many active investors focus on sentiment, momentum and price movements rather than fundamental analysis. This means active investors aren’t always seeking to identify undervalued or overvalued companies.

Not all active investors are obsessed with efficiency. Instead, they may prioritise short-term gains or follow market trends. The pervasive momentum and performance-chasing seen in stock market returns is not a phenomenon solely caused by passive flows. 

Remain sensitive

Despite these concerns, markets don’t appear broken. Imagine a major scandal rocking a large company: its stock price is likely to plummet due to concerns about future earnings. This scenario illustrates that markets still respond to fundamental factors.

We can reliably expect fluctuations in a company’s stock price if there are obvious concerns about its business model, demonstrating that markets remain sensitive to fundamental changes.

The growth of passive funds might benefit active investors in theory. Active investors can exploit mispricing, but short-term horizons and performance pressure often limit their ability to capitalise on these opportunities. Nonindex stocks and smaller markets may feel the impact of passive funds.

Companies not featured in mainstream indices may experience reduced liquidity, while noncore markets might experience pricing distortions. This could create opportunities for active investors willing to venture into these areas. 

However, their success will still largely be driven by fundamental factors such as revenue growth and profitability, showing that markets still reward companies with strong fundamentals. The rise of passive investing hasn’t changed this dynamic.

As markets evolve understanding these dynamics is crucial. The growth of passive investing requires active investors to lengthen their time horizons. However, the ease of switching to passive funds has shortened investors’ patience. Active investors must balance their short-term goals with the long-term benefits of fundamental analysis. 

Market changed

To make the most of this changing landscape focus on what works for you. Active is not necessarily better than passive, and vice versa. These are just tools that should be incorporated when trying to build a balanced portfolio. Have a clear understanding of your goals, risk tolerance and a long-term perspective. Don’t let sentiment drive your investment decisions.

It is challenging to separate genuine concerns about the impact of passive investing from complaints by those who have lost out due to its growth. However, the market has changed, and we should consider what that means.

Looking at the evidence, much of the market activity blamed on passive investing seems similar to patterns seen before, long before passives became so influential. This doesn’t mean passive investing has had no effect, but its impact might be overstated.

Passive investing may amplify market trends and make corrections more dramatic, but it’s hard to argue that markets are fundamentally broken.

The tried-and-tested advice still stands — work with an investment manager or take the time to educate yourself on how to blend the benefits of active and passive investing. By doing so, you will be well-equipped to make informed investment choices that help you achieve your financial goals regardless of market trends. 

• Luthuli is investment management director at Luthuli Capital.