Did Passive Investing Fuel A Bubble In Ultra-Large Tech Stocks?

Joe Weisenthal (0:10)

Hello, and welcome to another episode of the Odd Lots Podcast. I'm Joe Weisenthal.

Tracy Alloway (0:16)

And I'm Tracy Alloway.

Joe Weisenthal (0:18)

Tracy, do you remember our episode a few weeks ago with Mike Green?

Tracy Alloway (0:23)

I do indeed, fantastic episode.

Joe Weisenthal (0:26)

Yeah, this idea, and of course, for those who don't recall it, or those who maybe haven't listened to it, the topic was, what are the sort of distortions in the market that are being caused by the rise of passive investing? People are just throwing money month after month, paycheck after paycheck, into index funds. A lot of people think it's a really good trend, but there is more attention and more questions being raised by what does it really mean for markets and market structure when so much money isn't going towards individual security selection?

Tracy Alloway (1:01)

Right, there's this assumption that passive investing is actually good in many ways, because investors are paying lower fees. So over the long run, they make more money, but also in the sense that passive investing, because you're just putting money into these big benchmarks that are reflective of the market as it is, that you're not actually impacting the market at all. And only now are we starting to see some real criticism of that thesis and also some academic research, where people are saying that actually passive investing and benchmark index construction can impact the market itself.

Joe Weisenthal (1:40)

Right. And of course, passive investing, you mentioned the low fees. There is also a body of academic research on the side of passive investing, believers in efficient markets and so forth, who essentially say, look, the sum total of all active investors is just going to be the index itself, and you're unlikely to beat the market with your own stock selection. So why not just buy the market itself, and then you get the same return as everyone else, but at least you didn't pay the fees.

Mike Green's argument when we talked to him was, essentially, it's creating all these distortions because the money just sort of goes to the index itself. That drives the index higher, and anyone who's trying to buy individual stocks can't possibly compete with a strategy that's just put it all on the index.

Tracy Alloway (2:32)

Right, and there's this sort of underlying theme that's running through all of this, which is what does passive investing actually imply about the functioning of the market, and I suppose the state of capitalism, right? Markets are supposed to be funneling money in an efficient way, and if passive investing is causing these sorts of distortions, where these overvalued companies just get more and more overvalued, I guess then is capitalism really working?

Joe Weisenthal (3:01)

Exactly right. So today, we're going to explore this topic further because it's clearly something that's of growing interest. And we're gonna talk with someone else who's done research on this exact question, also making the argument that the rise of passive is creating weird, anomalous, bubble type behaviors in some stocks that's clearly different than the old days. And so I think we're gonna get more granular on what we're really seeing in the market that says something is weird about how the market is behaving specifically because of the rise of passive.

Tracy Alloway (3:40)

Great, let's go granular.

Joe Weisenthal (3:42)

All right, we're gonna go granular. We're gonna be talking today with Vincent Deluard. He's the Director of Global Macro for INTL FCStone. Major broker dealer recently came out with a report talking about the connection between passive investing and the sort of rise of these mega caps and the connection between the incredible performance of stocks like Apple and Microsoft and Alphabet and so on and what that has to do with passive investing. So Vincent, thank you very much for joining us.

Vincent Deluard (4:14)

Thanks for having me, a pleasure.

Joe Weisenthal (4:15)

First of all, before we get into the question of the distortionary impacts of passive investing, what is, I mean, some people debate what that even means, passive investing. And some people say, oh, it's a myth. Passive investing isn't even a thing or whatever it is, or that everyone is making some sort of active decision. But when we talk about this, how do you define the phenomenon that seems to define this sort of age in investing?

Vincent Deluard (4:44)

Yeah, absolutely. I mean, I've been in my work, I've just defined it as investing in market cap weighted indices. And I do realize that people use them for short-term trading, as a replacement to other vehicle, and that at the end of the day, there is a human behind it.