Investment process
The rise of price acceptors
The rise of passive investing over the last fifty years has been dramatic. As an active investor I like to keep an eye on this trend and reflect on how it impacts my active investment process.
In this post I will take a look at this.
Passive investing
Let’s define terms. This comes from a paper titled: ‘The Shift from Active to Passive Investing’, published by the Federal Reserve Board in Washington on May 15, 2020.
“Active strategies give portfolio managers discretion to select individual securities, generally with the investment objective of outperforming a previously identified benchmark. In contrast, passive strategies, including indexing, rules based investing, often to track an index by holding all of its constituent assets or an automatically selected representative sample of those assets.” (emphasis added)
The Fed paper adds: “Moreover, the growth of passive investing can be seen as part of a larger shift to systematic investment strategies, including smart beta and quantitative investment strategies, which may have significant implications for asset prices, risk management, and market microstructure (Giamouridis (2017)). (emphasis added)
My own definition
I come at the distinction between active and passive investing slightly differently. Any style of investing that is Price Accepting I think of as passive. Any style of investing that sees a distinction between price and value, is active investing. As Warren Buffett put it in the 2008 Berkshire Hathaway annual report: “Price is what you pay. Value is what you get.”
Active vs passive
A chart in a recent Economist magazine article illustrates the active vs passive trend. See article.
The numbers are probably higher than shown on this chart. A recent paper published by the Harvard Business School, titled The Passive-Ownership Share Is Double What You Think It Is, offers the view:
“While index funds held 16% of the US stock market in 2021, we put the true passive-ownership share at 33.3%. Our headline number is twice as large because it reflects index funds as well as other kinds of passive investors, such as direct indexers and active managers who are closet indexing.” (emphasis added)
So, investors who follow passive strategies include: indexing; use rules-based investing; systematic investment strategies; themed strategies; dynamic asset allocation; smart beta; quantitative investment strategies; as well as active managers who are closet indexing. They are all Price Accepting investors.
An ETF that invests in so called value stocks may be filled with stocks with low p/e ratios or low price to book ratios but that doesn’t mean these stocks are priced below fair value. They normally have low ratios for a reason. It would be absurd to think you could invest in stocks at bargain prices just by investing in an ETF of so-called value stocks. Value stock ETFs are Price Accepting.
The number of exchange-traded funds (ETFs) in the United States has steadily increased. Starting with 123 ETFs in 2003, this amount has grown to a total of 3,243 ETFs as of 2023. There are about 300 factor or smart beta ETFs and about 300 themed ETFs.
In a bizarre twist, a lot of ETF investors pursue active strategies even though they are price acceptors. That is, they practice some form of market timing, dynamic asset allocation or rotation strategy.
As prices of ETFs go up, demand goes up also
Demand for ETFs goes up as prices go up. You don’t have to take my word for it.
Consider what Howard Marks has written on this issue. Howard Stanley Marks is an American investor and writer. He is the co-founder and co-chairman of Oaktree Capital Management, the largest investor in distressed securities worldwide. In 2022, with a net worth of $2.2 billion, Marks was ranked No. 1365 on the Forbes list of billionaires. He wrote:
“We learn in Microeconomics 101 that the demand curve slopes downward to the right; as the price of something goes up, the quantity demanded goes down. In other words, people want less of something at higher prices and more of it at lower prices. Makes sense; that’s why stores do more business when goods go on sale.
It works that way in most places, but far from always, it seems, in the world of investing. There, many people tend to fall further in love with the thing they’ve bought as its price rises, since they feel validated, and they like it less as the price falls, when they begin to doubt their decision to buy.” (Marks, The most important thing illuminated: uncommon sense for the thoughtful investor, 2013) p27 (emphasis added)
Price Accepting investors accept higher prices even if the value isn’t there.
Price discovery and price volatility
As more investors pursue passive strategies, becoming Price Acceptors, one might wonder what impact this has on price discovery in the stock market.
The recent Pershing Square 2024 Interim Report from Bill Ackman sheds some light on this. Pershing Square might be thought of as a highly sophisticated Wall Street money manager. Pershing Square Holdings, Ltd. is a closed-ended balanced fund launched and managed by Pershing Square Capital Management, L.P. It invests in public equity and fixed income markets across the globe. The fund seeks to invest in stocks of companies operating across diversified sectors. It primarily invests in value stocks of companies. For its fixed income portion, the fund primarily invests in convertible securities and debt securities. It also invests through derivatives. The fund employs long/short strategy to create its portfolio.
Ackman writes:
“Equity markets have exhibited an enormous amount of single-name stock price volatility for even the largest companies when they surprise investors with even minimally below-expectation overall results or small misses on certain closely followed business metrics… Markets are also exhibiting an enormous amount of volatility when macro data surprises occur.” (emphasis added)
He explains why, in his view, this is happening:
“We believe that the growing index ownership as a percentage of stock market float has increased the impact that short-term, highly leveraged investors can have on price discovery as they now comprise a growing percentage of the market cap and daily trading of companies, and are important marginal buyers and sellers of a security. These shorter-term investors – which include so-called market-neutral and quantitative funds – use large amounts of margin, derivative, and total return swap leverage in their strategies. As highly leveraged market participants, these investors’ tolerance for mark-to-market losses is small, which contributes to stock price volatility as they can become effectively forced sellers when companies disappoint, even in the short term.” (emphasis added)
His conclusion for active investors:
“Greater stock market volatility is the long-term friend of the active investor with permanent capital who seeks to identify high-quality companies which are not dependent on the capital markets to implement their business strategies. While an earnings’ miss or other business metric disappointment in a quarter could reflect the beginning of deterioration in fundamentals, in many cases the impact of the disappointment has only a marginal effect on long-term intrinsic value.”
Pershing Square 2024 Interim Report
My thoughts
Ackman’s idea is that the rise of passive investing is leading to greater stock market volatility. While I agree with him that highly leveraged market participants may be causing greater volatility, I’m not sure I agree with his conclusion. I don’t think very short-term volatility caused by an earnings miss or other business metric disappointment will lead to too many buying opportunities. Warren Buffett waits for a fat pitch in his happy zone and these don’t come along very often.
Conclusion
Two things strike me in reflecting on Ackmans comments. First off, it sounds like price discovery by active investors is still working fine. It may result in heightened short-term volatility but active markets participants are still arriving at prices. My second thought is that there is nothing in Ackman’s observations that suggest the stock market is becoming more efficient. The stock market and individual stocks still seem capable of swinging from euphoria to fear, from fear to euphoria, from bull to bear and from bear to bull as they have over stock market history. Passive and price accepting strategies do not seem to be changing that.
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For readers wishing to dig a little deeper into the subject of active portfolio management, take a look at these posts:
The joy of higher return with no more risk
Buying stocks in your happy zone
The cornerstone of investment success
The under-performance of value stocks explained
Buying at average prices vs buying at very attractive prices
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I’m also on Twitter @rodneylksmith
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