Key Points
- Passive investing accounts for 50% of global equity investments, nearly doubling since 2012.
- This offers lower risk, simplicity, and higher long-term net returns than active investing.
- A shift from active to passive strategies has reduced short-selling activity, amplifying volatility in large-cap stocks.
- Passive strategies have reduced market liquidity and extended periods of mispricing, making market corrections slower.
Passive investing has surged in popularity over the past decade, revolutionizing financial markets by providing investors with a safer, lower-risk alternative to active strategies. Mutual funds and exchange-traded funds (ETFs) have enabled investors to adopt a “buy-and-hold” approach, scaling rapidly as passive funds gain traction globally.
Torsten Sløk, Apollo’s chief economist, highlights the profound effects of this trend, particularly its role in exacerbating market volatility and increasing the concentration of wealth in a small group of large-cap stocks, such as the “Magnificent Seven” tech giants.
The appeal of passive investing lies in its simplicity and cost-effectiveness. By tracking market indices through ETFs or contributing to retirement savings plans like 401(k)s, investors achieve returns that mirror the market’s performance over time, avoiding the complexities and risks of active portfolio management. Active investing, by contrast, requires rapid decision-making in response to market fluctuations, which can result in significant short-term gains and losses.
While passive investing has provided higher net returns for risk-averse traders, it has introduced unintended consequences. Sløk warns that the shift toward passive ownership has reduced market liquidity and increased price volatility. This phenomenon stems from passive funds’ tendency to amplify price movements, as their investment flows are less responsive to real-time stock price changes.
Additionally, passive investing contributes to market concentration, where large-cap stocks dominate. This trend drives up these stocks’ price-to-earnings (P/E) ratios, creating potential overvaluation. As passive ownership grows, the likelihood of mispricing also rises, and market corrections become delayed.
Another significant impact is the declining role of short-sellers in the market. As more active investors switch to passive strategies, fewer participants are willing to short large-cap stocks. This diminishes market counterbalances, making it riskier to short these stocks and fuel further volatility.
Over the last three decades, passive investing has grown to account for 50% of equity investments in mutual funds and ETFs globally, nearly doubling its share since 2012. While this growth highlights its benefits, such as reduced costs and stable long-term returns, Sløk underscores the importance of understanding its broader implications on market dynamics and risks.
