A temporary lapse of gravity

Research on the stock price effects of passive investing keeps piling up. Canadian professor Pouya Behmaram recently posted two partly overlapping papers (here and here) showing, first, how the share of indexed investment in a stock could be reasonably measured, and, second, that this has had a considerable impact on their pricing.

You may have seen my optimal Pareto post on the inelastic stock market. It was based on research showing e.g. that stock market investments unconcerned with pricing made the aggregate market value rise by as much as five times the amount invested.

This further research provides, in my judgment, a better measure of passive investment. The so-called Indexing Inclusion Ratio (IXI) captures, in addition to index funds and ETFs, so-called closet indexers. These are active funds that closely follow their respective benchmark weights, identified by actual fund holdings for 41,200 funds across 38 indices. This facilitates examination of individual stock effects, not just market impact.

Let’s first recap why this is important: Passive investments now make up half of mutual fund assets in the US and about a quarter globally. They constitute roughly a fifth of the total US market cap if we include ETFs, possibly twice that share if we include the remaining indexers, closet or otherwise.

And of course – as a share of net capital flows, passive investments may certainly exceed 100%.

These papers provide additional confirmation of the lower price sensitivity of passive investments, stating that as passive investors dominate, the overall elasticity of the prices decreases. This has profound effects on relative returns.

The good news, of sorts, is that it has lifted stock prices. From January 2000 to January 2021, a cap-weighted portfolio of the top third IXI stocks outperformed the bottom third by 325%, corresponding to a statistically significant annual average of 4% (percentage points). The divergence was especially strong after 2012, a period which also saw strong passive growth – and, incidentally, lacklustre performance of the size and value factors. Oh, strike incidentally.

The bad news is that it will not go on forever. Using the implied cost of capital or adjusting actual returns for earnings news and market flow shocks, Behmaram calculates that high IXI stocks have significantly lower expected returns. To the extent that their stock prices are inflated without corresponding fundamental improvements, this should not be too surprising.

So far, though, it hasn’t come to a halt. Let me quote what seems to be the only logical explanation: “Long-term secular growth in passive investing (…) effectively postpones the realization of lower expected returns until an equilibrium in passive investment is reached sometime into the future.”

I’ve spent many years extolling the virtues of patience. It seems this is no time to stop.