Prior to the rise of passive investing, funds management was about judgment. What was a company worth? How does that compare to where it is trading now? Differences of opinion about these led to exchanges, as individuals made different assessments and traded accordingly. This led to a process of price discovery, where all opinions were expressed through trades and an equilibrium levels was thereby found. Fund managers also tended to keep some cash in their funds for opportunistic buying and to manage redemptions.

That was the old days.

These days, passive investing accounts for more than 43% of the US equity market. Passive funds tend to hold almost no cash and while most track a market cap index, there are “smart beta” alternatives like equal weight, min-vol, etc.

To be sure, passive investing has been successful. S&P’s regular surveys show that passive investing in a core market index regularly beats most active investors, after fees. Success begets success, and passive investing has grown quickly around the world. This growth, however, has begun to change how markets work.

Which brings us to Tesla. Elon Musk’s disruptive electric car maker has captivated the driving world. The company spends zero on marketing, makes a range of highly sought-after cars and over the past few quarters has even turned profitable.

You may have heard that Tesla’s stock price has gone from US$220 to US$1,600 in the past year. This has seen Tesla overtake its rivals to become the world’s most valuable carmaker, making it worth more than Toyota, Volkswagen and Daimler combined – all while producing around 370,000 cars a year compared to Toyota, VW and Daimler’s 25 million combined.

Now I’ve been in a Tesla and I think they are wonderful cars. I’ve also been in an Audi and a Lexus and a Mercedes and thought they were pretty flash too. I do wonder, then, is the market having a bout of irrational exuberance with Tesla? At US$305 billion, could the nifty electric carmaker be a little overvalued?

Well, each to their own but at these levels I probably wouldn’t be a buyer. Or would I? What if I held a US index ETF?

Tesla could soon meet all the conditions for membership of the S&P500 index. If it does, then it would go into the index with a weight of around 1%. The three largest ETFs in the world all track the S&P500; the SPDR S&P 500, iShares S&P500 and Vanguard S&P 500 have a collective market cap of around US$640bn. There are many other ETFs that track the broad US market and many international ETFs that invest in the S&P500 as well, including in Australia.

If S&P put Tesla in the 500-stock index and these passive funds automatically reflect the index weights, then collectively just the top three will need to buy $6.4bn of Tesla stock, which could send its shares even higher.

A traditional active manager might look at Tesla and decide to wait on the sidelines. If they were already holding it, they may decide to sell. However passive funds have no such discretion. If it’s in the index, they must buy it at whatever price it’s trading.

In a market where passive investment is growing relative to active investment, this sets up a condition for momentum trading to succeed. As money flows into passive funds, the money is deployed into the index members at their current levels. If these flows force the index up, then new money buys in at even higher levels. Valuation metrics don’t matter because the index decides how much of each stock to buy.

There is also the other side of the trade. If markets fall and investors start to sell their holdings, how could passive flows impact prices?

Keep in mind that passive sellers must sell at the going price and they keep minimal cash on hand for redemptions. With 43% of the US market passive, a modest retreat by investors puts a whole lot of shares up for sale and there need to be enough discretionary investors on the other side of the trade to discover a price. If those investors sit on the sidelines and wait, there is the strong possibility of a large gap down in prices as passive funds are forced to sell.

Although passive investing in Australia is proportionately smaller than in the US, the same rules apply. Inward flows create a momentum effect on index stocks, no matter what the valuation ratios. Similarly, if only a modest proportion of investors decide to exit, then a lot of shares go up for sale – at any price.

Active funds would be exposed to any market volatility or distortions created by passive funds, but they would be much better placed to deal with them. Freed from being forced to buy or sell, having cash on hand to manage any redemptions and to opportunistically buy, and looking for bargains and avoiding overpriced celebrity stocks, active management should remain a core part of investor’s portfolios.

The tale of Tesla should make investors at least think about the mechanics of passive investing and the role that discretionary, active management should play in their portfolios.

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Mike S

Topical subject and you're wise to highlight the double-edged nature of passive investing. Mike Green of Logica Advisors did a very interesting podcast with Grant Williams covering the subject - worth a listen: (it's half the elength if you fast forwrd through Bill Fleckenstein's comments!).

Jo Park

great article