Market Update 17th February 2025

Passive Aggressive

One of my favourite behavioural studies is a group of people being given a picture and a description of a young man. He wears glasses, he’s introverted, doesn’t have many friends and lives with his parents. He is at university and the group are asked to guess what course he is on. A high percentage of them say computer studies.

The group is then told they are part of a behavioural study about how we routinely overestimate ourselves. You can’t tell what university course someone is on just by looking at a picture and being told he doesn’t get out much. He could be doing anything.

They are then invited to change their answer now that they know this. Hardly anyone does. They accept the point might be true in the broad sense, but individuals feel they have specific insight in this particular case.

I won’t name them for these purposes, but last week we met two funds who both had things to say around the active vs passive debate and how they perceive themselves within this. They are successful funds with good long-term records.

Both are relatively small, founder led funds. The first manages $2.4bn and told us around 5% is held by founders and management. They hold a lot of contrarian positions and believe the financial independence of the managers is crucial to their independence of thought, which drives the fund strategy. It can be difficult on several levels to hold on to these unloved positions.

I thought crikey. They seem to be saying if you want to be contrarian then it is helpful to have $120m of your own money to give you enough freedom from internal and external pressure to be able to do this without having to worry too much about being sacked.

Trust me I understand there is pressure to perform and do well with other people’s money – there should be – but would anyone consider these extreme dynamics to be healthy and an overall benefit to any industry? Would you aim to create this amount of pressure to follow the herd if you started from scratch?

The second fund went into a bit more detail. Much of the meeting was taken up by his views around the whole philosophy of active investing in the context of the last few years, where active outperformance has become increasingly hard to find.

His view is that everything about the fund must be orientated towards giving him and his team the best chance of beating passive funds, which he sees as his true competitors.

Passive funds naturally buy outperforming companies and sell underperformers. From this starting point, he sees three ways to beat passive funds. First is to invest in outperformers ahead of the index composition, second is to invest in outperformers with a higher concentration than the index, or third is to invest in outperformers with more attractive valuations. Go early, go big, or go cheap.

According to Morningstar, just under $900bn of inflows went to index trackers in 2024 vs $165bn of outflows from active funds. Both numbers are dominated by flows in and out of US equities.

Despite an apparently inbuilt pull towards over-confidence, many investors appear to have thrown in the towel on active investing, particularly in the US. Barely a day seems to go by on social media without a host of articles and posts about the benefits of passive investing. There is a growing narrative that it is “too difficult” to outperform with active management and so we’re better off not trying.

Innovation is not regularly accused of over-confidence and is hardly long enough or clever enough to end the debate around active vs passive investing, but I believe we are in an extreme place and will not necessarily stay there.

The number of stocks outperforming the S&P 500 is currently just below 30%, well below the 21^st century average of 47% and a peak of over 65%. It was just below 60% as recently as 2022. The fewer stocks there are outperforming, the more difficult it is for a manager to outperform. This creates a strong tailwind for passive investing.

UCITS rules make it difficult for a fund to be more concentrated than the current level in the US, so one lever of outperformance is effectively unavailable.

This will unwind at some point – I don’t know when, but it will. I was shown not one, but two academic papers this week. One was on this point. If you could forecast changes in concentration then you could build a useful trading strategy around it, but it’s not really forecastable. It appears to mean revert over time, but as ever the timing is the thing you would really want to know.

What about a second lever – invest ahead of the index composition. It might be a little late for that.

Which brings us to the third – valuation. This is the only one available to us right now. I was shown a second academic paper on this point. Essentially it aims to measure the impact of passive funds on the performance and valuation of stocks. Passive funds held around 5% of the US market in 2000, but that increased to more than 25% by 2020.

The paper concludes that passive funds have had a large effect on highly indexed stocks and explains nearly all of the recent outperformance of these companies. As well as the continued dominance of the big tech names, it also explains for example the continued outperformance and premium valuations of large vs small cap indices. There are very few small cap passive funds due to liquidity constraints.

If or when concentration levels drop, you can reasonably expect these trends to reverse, as passive funds become equally enthusiastic sellers.

Robert Fullerton – Senior Research Analyst

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