Passive investing’s rise hasn’t ruined the stock market, says Jeremy Grantham’s GMO



The rise in passive investing marks one of the stock market’s “most profound changes” ever, but its popularity hasn’t ruined the market, according to analysis from Jeremy Grantham’s GMO. 

GMO, co-founded by legendary investor Grantham, has been getting questions from clients about the impact of passive investing on markets, the firm’s co-head of asset allocation Ben Inker and team member John Pease said in their letter to clients for the second quarter. 

While the increase in passive investing may have intensified “a few features of today’s markets,” including the rise of megacap stocks and the underperformance of value and small-cap equities, “any effect was likely quite small,” according to their view.  

“Passive investing cannot change the basic math of investing in the long run,” they said. “If passive investing helped push up the prices for megacaps or push down the prices for other stocks in a way that was not justified by their underlying fundamentals, future returns will be better for the undervalued stocks and worse for the overvalued ones.”

Read: Markets are ‘fundamentally broken’ due to passive investing, says David Einhorn

For many active managers, beating the market persistently has been difficult. 

For example, a scorecard report from S&P Dow Jones Indices that analyzed active mutual funds and exchange-traded funds showed that 60% of all active large-cap U.S. equity funds lagged the S&P 500 in 2023. That marked the 14th straight year of underperformance for a majority of actively managed large-cap U.S. stock funds, according to the scorecard.

“Passive is not some temporary investing fad,” GMO’s Inker and Pease wrote in their letter. “Passive funds have overtaken their active peers for a very good reason — they are much cheaper than active management.”

Unlike passive funds, active funds aim to outperform the market. This involves “significant” ongoing research that contributes to the higher cost of active managers, according to GMO’s letter.

The firm’s first exchange-traded fund, the actively managed GMO U.S. Quality ETF
QLTY,
which launched in November, is beating the S&P 500 index so far in 2024. 

Shares of the ETF have climbed 18.5% this year through Monday, exceeding the S&P 500’s 16.8% rise over the same period, according to FactSet data. The fund has an annual management fee of 0.5%.

The fee for the Vanguard S&P 500 ETF
VOO,
a popular fund that passively tracks the stock-market index, is smaller, with an expense ratio of just 0.03%. Like the S&P 500, shares of the passive ETF, which has $481 billion of assets under management, are up 16.8% this year through Monday.

Read: How GMO’s ETF is beating the S&P 500 this year — without Nvidia

“It is important to keep in mind that whatever effects the rise of passive investing has had, it doesn’t change the way that stock investors make money in the long term,” said Inker and Pease. “The primary drivers of long-term returns in the stock market are the future cash flows of the underlying companies and the prices that investors pay for those cash flows.”

In their view, passive investing shouldn’t “meaningfully change” cash flows.

“If passive investing does have some lasting impact on prices, those prices impact the timing of returns, not their ultimate level,” they said. “If the price of the megacaps was artificially pushed up by passive flows, then those stocks are overvalued and their future returns will be subpar.”

GMO also considered the influence of passive investing on value stocks.

“If the higher price sensitivity of the holders of value stocks has led to them trading at too wide a discount to the market as money has moved to passive vehicles, value stocks will outperform in the future,” wrote Inker and Pease.

They said the reality is “not so much that the rise of passive investing ruins markets, but only that it changes them.” For example, “it changes how much short-term investors should care about flows,” or potentially “how much long-term investors should bank on mean reversion,” they noted.

“It changes how all investors should think about correlations, seeing as both passive flows and passive allocations might mechanically introduce (or reinforce) sources of asset co-movement,”  wrote Inker and Pease. “Our responsibility as an active manager is to notice these changes, think of what obstacles and opportunities they create, and make money from them.”

Meanwhile, whatever impact passive investing has had on “market efficiency,” they said, it will probably be “smaller going forward.” As they see it, the transition to defined-contribution retirement plans that probably helped fuel the growth of passive investing “is coming to an end.” 

Under defined-contribution plans, like 401(k) plans, employees manage their own retirement accounts by selecting from a lineup of funds. That’s in contrast to defined-benefit plans, under which an institution has responsibility for investing retirement assets on behalf of employees. 

“Defined-benefit plans (and annuities) have already gone from making up 82% of retirement assets in 1974 to 37% of those assets in 2023, and two-thirds of what remains in defined-benefit plans are in government-sponsored plans (which tend not to be reallocated),” wrote Inker and Pease. Under defined-benefit plans, they noted that a public or private institution that is investing money for employees often does so through active managers.

While plan participants in defined-contribution plans would “presumably be happy to receive” higher returns from active managers, “what is much more salient to the sponsoring corporation are the implications should those active managers underperform,” the GMO letter said. “In that case, the sponsor runs the risk of participants suing them for their perceived incompetence.”

The U.S. stock market closed mostly higher Monday, with the S&P 500 index
SPX
rising 0.1% for a fifth straight day of gains to book a fresh record closing high. That marked its longest stretch of daily gains since January, according to Dow Jones Market Data.

“Passive has unquestionably changed the landscape of investing,” said Inker and Pease. “But it hasn’t changed the math of investing, and at the end of the day it is the math that matters most.”

Read: Is your active mutual fund beating the U.S. stock market this year?



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