Active investors! Assemble

SPEAKER_1 (0:00)

Within just a few years, we will spend more on interest payments than we will on national defense. That is a right flashing warning sign that we are on an unsustainable path. And clearly, it is unsustainable because the fastest growing part of our budget is interest payments. And when you have a debt that's growing faster than your economy, obviously something we'll have to give.

SPEAKER_2 (0:20)

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Ethan Wu (0:36)

Pushkin.

At the end of 2023, US markets hit a big milestone. Passive investing, where you take your money and you shove it in the market and you do just about nothing with it, for the first time ever, exceeded active investing. That's according to data from Morningstar. This is a big change, and as some market watchers worried, are markets really markets if everyone is just buying the index? This is Unhedged, the Markets and Finance show from the Financial Times and Pushkin. I'm reporter Ethan Wu, here in the New York studio, joined from London by markets columnist, Katie Martin, who loves complaining about passive investing. Isn't that right?

Katie Martin (1:20)

I don't love complaining about it. I don't want to get any more emails about this. But it's interesting.

Ethan Wu (1:28)

One of the most interesting topics in markets, it's very controversial, as you alluded to, and your piece on this last month, Katie, generated, I'm looking right now, 329 FT readers with something to say, and I'm sure a boatload more emails.

Katie Martin (1:41)

Yes. If you want to annoy people or get them very kind of excited and feeling righteous about things, then my advice to you is write about passive investment.

Ethan Wu (1:51)

Well, let's just take it back to basics for a second. I mean, I think people may know this, but it took decades and decades for kind of the collective wisdom of the markets to be that active investing, for the most part, in the long term, on average, sucks, that most people can't beat the index on a consistent basis.

And you see kind of over time funds bleeding out of old, staller active managers, like, you know, the Franklin Templetons of the world and heading into these S&P 500 or other equity index trackers. This is a long-running story, and it's moved very slowly, but we're now kind of reaching critical mass. And as markets have shifted in that direction from active to passive, you've heard a kind of growing crop of concern about what it might do to markets themselves. And so maybe just talk a bit about that, Katie. What is the problem with just a lot of people owning the market?

Katie Martin (2:43)

So there's a couple of things.

Passive investment is still a bit of a bogeyman for people who, for whatever reason, just hate it. Yeah. Because often, it's like if you're an active manager who's out there kind of picking stocks, then passive investment is just eating your lunch. And so a lot of people who do pick stocks for a living or do really kind of sophisticated investment strategies will tell you that the reason their strategies are not working is because of passive. There's a lot of whinging about passive and how it's not fair and this kind of isn't how the game is supposed to work. And it's just one of those reasons that people throw out there when their portfolio is not working terribly well. Things are always the fault of either the Fed or of passive management. So some of that is kind of valid-ish, and some of it needs taking with a bit of a pinch of salt. But one paper, like academic paper, that really caught my eye in recent weeks, published by the NBER, was basically saying that the researchers are sort of testing out this theory that passive investment makes stocks behave weirdly and stops individual stocks from being able to respond properly to news, which is like the whole point of the stock market, right? Is that it rewards companies that are doing well, and it punishes companies that are doing badly.

And the research basically finds that it is indeed provable that stocks are bad at reflecting news that is pertinent to them if they are in a big index like the S&P 500 So to figure this out, they look at currency shocks, sort of big movements in the currency markets, and they figure out how all things being equal, they should affect companies that derive lots of revenues from the countries where those currencies are. And they say that actually, you find that if a company is in the S&P 500, which is the most heavily tracked index out there, it has a 60% lower sensitivity to FX shocks, to currency shocks. Now, they tested this to death, so they've looked at companies that moved in and out of the index. They also tried to control for things like, well, if you're a big company, you've probably got quite a sophisticated currency hedging program, so does that dull the kind of sensitivity, or if you are a really big company that's big enough to be in the S&P 500, do you have lots of manufacturing, for example, abroad that means that you have natural currency hedges that dull the impact? And they found that even when you control for all of that stuff, the sensitivity is still diminished as a result of things being in this index. And that kind of opens up some pretty interesting questions around, as I say, the whole point of stock markets is that investors are supposed to be able to reward companies that do well and punish companies that do badly.