Collective wisdom: but has the rise of passive investment brought about a drop in diversity among investors?
It is estimated that close to a third of the market capitalisation of global equity markets – or around $ 20 trillion – is now managed passively. So it is important to think about how this may be impacting the returns of the broader market, and also its potential impact on active strategies.
We need to start with the simple idea of how single stocks, and hence markets, are broadly efficient.
The best illustration is the example of a room of people guessing the number of jellybeans in a jar. In repeated experiments, the average of all the guesses turns out to be closer to the number of jellybeans than any individual estimate. This is known as the wisdom of crowds.
For the wisdom of crowds to work successfully, the population needs to be engaged in the same activity (guessing the jellybeans) and diverse – some optimists, some pessimists, some more engaged and some less engaged.
Returning to the stock market, what this means is that most of the time, the price of a given stock is an average of the estimates of all the market participants – so long as the majority of them are concerned with what the equity of the company in question is genuinely worth. So how do active investors look to make a profit if the wisdom of crowds is such an effective phenomenon?
Essentially, investors are looking to identify a decline in the diversity of the population – an overwhelming predominance of optimism or pessimism, or a particular interpretation of the future crowding out other possibilities.
At such a time, the efficiency of the system breaks down. Investors make a profit when they take advantage of the price and then wait for the efficiency of the system to recover. For active management to be successful, it is the efficiency rather than inefficiency of the market overall that is of greater importance, not the other way around.
This is a mistake that even active managers themselves frequently make. Were the inefficiency to dominate, share prices would largely be a random walk.
Of course, this description is simple but I believe it is fairly representative of what the individual active manager is trying to do. However, few investors succeed in identifying a meaningful number of these diversity breakdowns over time, and few have the processes or time horizon to reap the benefit from their analysis with sufficient consistency.
The opportunity to just go with the average is compelling. Once you have resolved that the wisdom of crowds is smarter than you, just go with that. But the problem occurs when too many people step away from guessing the jellybeans and just go with the average. Because they are part of the system, diversity degrades and the crowd, whether they see it or not, becomes increasingly dumb.
As the strategist and author Michael Mauboussin points out in his book Think Twice, “Unchecked devotion to the wisdom of crowds is also folly”. The whole proposition of passive will only work if the significant majority of actors in the market are genuinely trying to arbitrage between the price and the value.
This applies to smart beta as well. Smart beta investors are simply trying to gain an edge on other passive funds by mirroring strategies that are alternatives to the cap-weighted index, and which have worked historically.
In my opinion, with a third of market participants now acting as followers, we have a breakdown in diversity and a less efficient market. What this means for active managers is that opportunities to identify arbitrage are likely to increase – but that the time for efficiency to re-assert itself could be much longer and noisier. So returns from active investing are likely to be markedly superior over time but, for both investors and clients, staying the course will be the challenge.
And what does this mean for markets as a whole? A brief look at market history tells us that whenever any asset class, strategy, style or sector experiences such a surge of popularity that it crowds out other methods, the ensuing outcome, after a peak in demand, tends to disappoint – in some cases materially.
We have had episodes such as this many times before; a market which undergoes a phase of consolidation is often accompanied by a meaningful change in longer-term leadership. This provides the most challenging environment for passive strategies, because the need to rebalance their portfolios to accurately reflect the market becomes more frequent, and thus brings extra costs, which then impacts on their ability to reflect the market.
However, it is smart beta that faces the greatest challenge under such a scenario as it relies on the persistence of historically-observed ‘effects’ – something less likely in a more volatile situation.
While this is only one interpretation of the effect of the growth of passive strategies, as the old saying goes, there is no such thing as a free lunch. Arguments that focus on the low fees associated with passive strategies ignore the opportunity cost of not using active strategies. Therefore, the next time you see a chart of projected growth in passive and smart beta strategies, it may be wise to consider how this may be impacting on market efficiency and the long-term opportunity of breaking from the crowd.
Paras Anand is head of European equities at Fidelity International