Is the Rise of Passive Investing a Self-Fulfilling Prophesy?

A recent FT article suggests that the rise in popularity of passive index funds is driving a trend of increasing correlation in equities markets. That could mean diminishing returns for the traditional stock picking model. After a positive 2017 for active fund managers, almost half of US large-cap equity fund managers managed to beat their index last year, 2018 has seen a return to high rates of correlation in the direction stocks in common indices have been moving. Correlation between the movement of S&P 500 stocks has risen to 52% this year from a low of 9% as we entered 2018. Many analysts are starting to consider this as a return to the mean with last year an aberration in a trend leading towards higher correlation.

For those investing online, this raises the question of whether it still makes sense to pay higher fees for actively managed funds or to put the time and effort into analysing individual stocks to build a DIY portfolio. Heightened market nerves likely have a role in the rapid move back towards high correlation as stocks tend to move in greater unison during periods of increased volatility. However, many market analysts believe that while volatility is certainly behind the pace of the correlation shift over the past 3 months, which Goldman Sachs data indicates has been the fastest since the 1987 Black Monday markets crash, the broader trend is due to increased capital inflows to passive funds.

Passive funds, or ETFs, that most commonly track equity indices or commodities have risen significantly in popularity with institutional investors as well as retail investors. They are a far cheaper way to diversify risk than actively managed funds and over the longer term often also perform better. Active fund managers have been struggling with widespread scrutiny over recent years that has highlighted that very few of them actually beat their benchmark index with consistency over the medium to longer term. That has led to serious questions over what then justifies the higher fees investors have to pay for active management.

Periods of volatility and stock market drops are theoretically when active stock picking and fund managers should come into their own. ‘Protecting the downside’ is a major defence of stock picking over passive funds. Quoted in the FT, Tom Clarke, portfolio manager at William Blair, believes the current market environment will prove to be a severe test of many active managers. He commented “active managers that aren’t able to do that (protect the downside) will have trouble surviving”.

However, there is also a strong argument that the current trend towards strong correlation within indexes will prove to be cyclical in the long run. If the value of stocks rise and fall because of the index they are in and not intrinsic merit, this would be expected to distort value over time. Eventually it would be expected that the value of stocks that have shifted significantly away from their fundamentals with their index would return to their mean. That could reignite the potential for active stock picking to outperform index tracking.