As assets under management in passive equity products surpassed the assets under management in actively managed equity products in Q4 2023, some market observers raised concerns that this could impact the efficiencies of the equity markets around the world.
The main reason for this concern is that passive products buy a security because it is a constituent of an index and not based on an analysis of the fundamentals or the evaluation of the company’s business model. In other words, passive products may buy stocks—thereby holding up their price—that may have a very bad balance sheet or decreasing business which active investors wouldn’t buy because of their fundamentals.
Generally speaking, this concern sounds valid, but a closer look could lead one to a different conclusion. This line of argument could be pertinent for passive investments, but it doesn’t take the other side of the asset management spectrum—active management—into consideration. Active managers can exploit these market inefficiencies to generate outperformance (so-called alpha) compared to the respective market indices.
Graph 1: Overall Assets Under Management in Equity Products by Management Approach (in bn EUR)
Source: LSEG Lipper
In a regular market environment, the transactions by active managers should keep the markets efficient since they are based on fundamental data and the expectations of the portfolio managers. Some market observers doubt this point, since a number of asset managers have tied their portfolios to a market benchmark and manage their portfolios with restrictions on the tracking error and/or deviations in sectors/regions and securities compared to their index. On the other hand, securities lending used by passive products which use securities lending strategies to juice returns and offset at least parts of their management fees should help keep the markets efficient. This is because the lent securities are normally used to build short positions in those securities.
Even though these concerns about market efficiency over the rise of passive products point to a real threat, it can also be said that possible inefficiencies will be arbitraged by active managers and, therefore, will be only temporary.
But is this “threat” really a real threat? The Efficient Market Hypothesis (EMH) by Eugene F, Fama said that one can identify an inefficient market by whether there are a disproportionately high number of outperforming active portfolio managers. We can’t find any evidence of a disproportionately high number of outperforming active managers within the current market environment (Please see our respective report for the year 2023 on this topic). This means that the markets seem to be efficient despite the rise of assets under management in passive products. As for this, one needs to bear in mind that these kinds of statistics are far away from being a perfect measure for market efficiency.
Nevertheless, nobody currently knows at what point markets start to become inefficient. Therefore, regular reviews are needed to identify trends which are a hint for, or are caused by, market inefficiencies.
This article is for information purposes only and does not constitute any investment advice.
The views expressed are the views of the author, not necessarily those of Lipper or LSEG.
