This is an audio transcript of the Unhedged podcast episode: ‘Active investors! Assemble

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Ethan Wu
At the end of 2023, US markets hit a big milestone — passive investing, where you take your money and you shove it in the market and you do just about nothing with it, for the first time ever exceeded active investing. That’s according to data from Morningstar. This is a big change and it has some market watchers worried. Are markets really markets if everyone is just buying the index? This is Unhedged, the markets and finance show from the Financial Times and Pushkin. I’m reporter Ethan Wu here in the New York studio, joined from London by markets columnist Katie Martin, who loves complaining about passive investing. Isn’t that right?

Katie Martin
(Laughter) I don’t love complaining about it. I don’t wanna get any more emails about it, (both laugh) but it’s interesting.

Ethan Wu
One of the most interesting topics in markets. It’s very controversial, as you alluded to, and your piece on this last month, Katie, generated — I’m looking right now — 329 FT readers with something to say and I’m sure a boatload more emails.

Katie Martin
Yes. If you want to annoy people or get them very kind of excited and feeling righteous about things, then my advice to you is write about passive investment.

Ethan Wu
Well, let’s just take it back to basics for a second. I mean, I think people may know this, but it took decades and decades for kind of the collective wisdom of the markets to be that active investing for the most part in the long term on average sucks, that most people can’t beat the index on a consistent basis and you see kind of over time, funds bleeding out of old stalwart active managers like, you know, the Franklin Templetons of the world and heading into these S&P 500 or other equity index trackers. This is a long-running story and it’s moved very slowly. But we’re now kind of reaching critical mass. And as markets have shifted in that direction from active to passive, you’ve heard a kind of growing crop of concern about what it might do to markets themselves. And so maybe just talk a bit about that, Katie. What is the problem with just a lot of people owning the market?

Katie Martin
So there’s a couple of things. Passive investment is still a bit of a bogeyman for people who, for whatever reason, just hate it largely because often it’s like if you’re an active manager who’s out there kind of picking stocks, then passive investment is just eating your lunch. And so a lot of people who do pick stocks for a living or do really kind of sophisticated investment strategies will tell you that the reason their strategies are not working is because of passive. There’s a lot of whingeing about passive and how it’s, you know, not fair and this kind of isn’t how the game is supposed to work. And it’s one of those reasons that people throw out there when their portfolio is not working terribly well. Things are always the fault of either the Fed or of passive management.

So some of that is kind of valid-ish and some of it needs taking with a bit of a pinch of salt. But one paper, like academic paper that really caught my eye in recent weeks, published by the NBER, was basically saying that the researchers are sort of testing out this theory that passive investment makes stocks behave weirdly and stops individual stocks from being able to respond properly to news, which is like the whole point of the stock market, right, is that it rewards companies that are doing well and it punishes companies that are doing badly. And the research basically finds that it is indeed provable that stocks are bad at reflecting news that is pertinent to them if they are in a big index like the S&P 500. So to figure this out, they look at currency shocks at sort of big movements in the currency markets and they figure out how, all things being equal, they should affect companies that derive lots of revenues from the countries where those currencies are. And they say that actually, you find that if a company is in the S&P 500, which is the most heavily tracked index out there, it has a 60 per cent lower sensitivity to FX shocks, to currency shocks.

Now, they tested this to death, so they looked at companies that moved in and out of the index. They also tried to control for things like, well, if you’re a big company, you’ve probably got quite a sophisticated currency hedging programme. So does that dull the kind of sensitivity? Or if you are a really big company that’s big enough to be in the S&P 500, do you have lots of manufacturing, for example, abroad, that means that you have natural currency hedges that double the impact? And they found that even when you control for all of that stuff, the sensitivity is still diminished as a result of things being in this index. And that kind of opens up some pretty interesting questions around, as I say, the whole point of stock markets is that investors are supposed to be able to reward companies that do well and punish companies that do badly. What if that’s not a thing anymore?

Ethan Wu
Yeah. If you have a big chunk, perhaps more than half of the market buying stocks for a reason, that is not, I believe in this stock, but rather it is on a list of stocks that S&P Dow Jones Indices told me I should own, then you’re going to react less to kind of incremental information. I think that’s very intuitive and in some ways, it’s good that academics are able to sort of demonstrate this.

Katie Martin
Yeah.

Ethan Wu
It’s an awkward place to be though, just intellectually speaking, right, Katie, because in good conscience, it’s hard to tell most people like, you should actually pick stocks. Like, help markets be more efficient, help enforce the efficient markets hypothesis by you personally allocating your money to to active funds because we know that they . . . 

Katie Martin
Pick a winner, right? Everyone loves picking a winner. You know, everyone loves kind of making their fortune. You know, buying Apple stock when it was worth, you know, tuppence ha’penny. And now look at my huge, you know, riches and but yeah, this is exactly the conclusion that the paper comes to, which is that passive investment, quotes appears to be undermining the official markets hypothesis. So as you say, it’s quite a big sort of philosophical point because if you, you know, and I don’t kind of wanna get all kind of, you know, super philosophical here, but if you get to the point where even more of the market is eaten up with passive investment, then what does the index tell you? Does it tell you how corporate America is performing, or does it tell you how much money is in the market? And at a certain point, it’s just got to be an index of how much money is in the market. And that’s a weird place to be.

Ethan Wu
I think, to sort of add to the maybe icky feeling and sort of the complicated situation here, Katie, it’s that, you know, we talk in the show seemingly nonstop about the Mag Seven, right, the Big Seven tech stocks — maybe at this point minus Tesla, so maybe it’s six — at the top of the index that drives the stock market gains. If you’re buying the S&P 500 you are like, almost by definition taking a huge mega super long position on like the fate of Microsoft and Google and Meta and so forth.

Katie Martin
Super, super, super long. You’re like 28 per cent exposed to these seven companies. And best of luck with that, everybody.

Ethan Wu
Yeah. So like your retirement fund like depends on how Satya Nadella runs Microsoft, right. And is there something weird or gross or unwise about basically buying in at huge, elevated valuations for some of these very popular tech stocks, which are getting compared to the dotcom bubble right now? Is market exposure with highly concentrated markets really market exposure properly conceived of?

Katie Martin
Is it problematic? Definitely, yes. Do I know what to do about it? No. I mean, there is a kind of argument that so there’s this idea that all indices are like these kind of black box passive collections of numbers. Human decisions go into what is in an index. And I guess there is an argument that the S&P 500 index has gone wrong, because you do have these gigantic companies sitting on the top of it that are just, they’re just sucking more and more and more money and they make it harder and harder for people to kind of make successful individual stock picks. And it means that people are, you know, on a market capitalisation basis through that index, 28 per cent exposed to these companies, which, by the way, are trading at a price/earnings ratio of like, you know, forward earn p/e ratio of like 37 times compared to the S&P overall, which is 25 times, which is high enough. But 37? Ye gods.

So all of a sudden, it means that investors — you know, mom and pop investors and big institutional investors — are all exposed to this really tiny clutch of companies, which, you know, the real joke here, they all share really common risks around regulation and around China. And, you know, it’s just not impossible to imagine a world in which this kind of goes horribly wrong. The flip side there is that actually investing in companies like Apple and Microsoft is about the closest as you will get to a safe haven in investment right now. These things are just unassailable. They are just rock-solid. Nvidia results tomorrow. Ethan Wu, are you excited? Oooh, be excited.

Ethan Wu
I’m very excited. There’s a related question to me, which is if everyone is doing passive investing and supposedly that makes markets less efficient and like less sensitive to incremental information and worse at pricing it in, shouldn’t that mean there are bigger pricing discrepancies between actual market prices and fundamentals for a smart active manager or a hedge fund to exploit and make money on?

Katie Martin
Ethan, Ethan, Ethan. I’m charmed by this idea, but fundamentals matter. Like every year, you know, the kind of active management crew will say, this is the year that management is gonna shine and that fundamentals are really gonna matter in stocks. And I’m like, uh-huh, cool. (Laughter)

Ethan Wu
How many times have you heard this is a year for alpha, not beta.

Katie Martin
This is so a year for alpha. This is so the year for stockpickers. Hmm, OK then. It’s also the year for UK stocks. (Ethan laughs) Look, maybe. I don’t know. I don’t have a crystal ball. But I do know that this kind of rise of passive is giving rise to some quite weird patterns in markets. And it also means yeah, first of all you’ve got a massive exposure to the Mag Seven.

Second of all, if you buy the S&P on a kind of index basis, you’re buying an index that’s pretty much at a record high. Now let’s have a little argument about whether that matters, because it feels icky. And you know, if you’ve got some cash sitting somewhere in a money-market fund or in a deposit somewhere, you could think, do I really wanna take that money out of that really safe place and put it into stocks that are trading at these sorts of levels? A little log thing the other day from Duncan Lamont at Schroders — hello, Duncan — was saying that actually, it’s fine to buy stocks at the high. And if anything, they tend to perform somewhat better in the 12 months after a period where they’ve been at a record high than they do when they haven’t been at a record high. And although we get excited about all-time highs in stocks, they are at or around all-time highs in the US like roughly 30 per cent of the time. So actually, maybe this is all fine. Maybe we’re worrying about nothing and people are making lots of money and just trying to overcomplicate it for their own kind of reasons but . . . 

Ethan Wu
Yeah, I think it’s probably right that passive investing represents the best scalable equilibrium for most people, right? They’re always going to have stories about some strategy that works better than passive investing. And I mean, look at what the big hot strategies are now, right? It’s, you put your money with Citadel and they do some kind of insanely complicated multi-strategy options hedging, blah, blah, blah that does not scale beyond a relatively small pool of capital such that they have to prevent people from putting more money into Citadel because they can’t scale it that far, right?

Katie Martin
And sometimes these kind of clever, clever strategies deliver like massive returns and sometimes they don’t. Whereas at least, you know, if you’re just sort of sticking with the stock market. Yeah, you’ll have some rubbish years. 2022 is rubbish, for example. But, chances are over the long term, you’ll kind of be fine.

So, you know, there is a school of thought that actually, you know, these indices and passive investment, you know, yes, it feels like you’re kind of following the crowd and just sort of doing what everyone else is doing.

But actually this is an incredibly sophisticated and high-class product that is exactly the same whether if you’re buying it, if you’re like you, Ethan Wu, or you, institutional fund manager somewhere. It’s the same. It’s the same thing. It’s an incredible democratisation of the market that other private markets are now trying to kind of emulate, like private equity, for example.

And yeah, maybe we should stop worrying about it. But I do think we should also just be aware of the kind of philosophical and practical wrinkles that this whole thing can throw up because, yeah, if it all goes wrong one day, we don’t want that to be a huge surprise.

Ethan Wu
Yup. The passive grumblers have a point. What are we gonna do about it?

Katie Martin
The grumblers are always gonna grumble, Ethan. That’s the thing.

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Ethan Wu
That should be the tagline for this podcast.

Katie Martin
Grumblers gonna grumble.

Ethan Wu
Grumblers gonna grumble. All right, Katie, we’ll be back in just a moment with Long/Short.

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Hey listeners, we are doing a listener questions episode in the near future. If you ever wanted to ask me, Katie, Rob, or any of the other Unhedged crew about what we think about markets, finance or life, whatever, send it to us: ethan.wu@ft.com.

Welcome back. This is Long/Short, that part of the show where we cheer things we love, grumble about things we hate. Katie, I am long RuneScape.

Katie Martin
You’re long what now?

Ethan Wu
I’m long RuneScape. The legend Louis Ashworth at Alphaville has just written a monster of a post about RuneScape, the private equity-owned, online massive role player game that taught millions of children, including me, how to do arbitrage trades, what value chains are and how to get scammed on the internet.

Katie Martin
I need to read this. I don’t understand it at all.

Ethan Wu
It’s basically like a, it’s a video game that was really big in the 2000s and the 2010s. And it has a pretty sophisticated economy. And there were lots of, you know, little children with their grubby hands, including, you know, 10-year-old Ethan Wu, basically trading the bid-ask spread, you know, buying something a little below the market price, selling it a bit above the market price. And there were all these in-game mechanics that kind of taught you how to do that. They called it merching. And Louis has written, it’s sort of a brilliant piece on the valuation of this company and there’s all these questions about is the player base real or is it just bots and computers? But I’m long RuneScape. What a great game. A classic. Influenced a generation of private equity drones.

Katie Martin
So it’s all RuneScape’s fault, basically is what you’re saying.

Ethan Wu
That’s right. Yeah, yeah, yeah. That’s right. Katie, are you long or short something?

Katie Martin
I’m also long something, sorry. But I got back on my bike.

Ethan Wu
Oh, wow.

Katie Martin
So I am long cycle commuting again. I haven’t sat on my bike since October when I got knocked off it again, but I decided I miss it too much. And I’ve got back on my bike, and this is my last shot at this.

Ethan Wu
Don’t say that! (Laughter)

Katie Martin
If I get knocked off it again, that is it. I’m selling it. I am not cycling anymore. But I’ve done this for like 15 years. And then I took like, I don’t know, three months out and I just can’t hack it. I need my bike.

Ethan Wu
Listeners sent in some delightfully kind and supportive emails when you first talked on the show about getting hit by, what was it, a van? You got hit by a van?

Katie Martin
Yes, I got hit by a van.

Ethan Wu
A lot of bike safety tips from the listeners. I think they must have felt bad because I called it your hard landing. Which . . . 

Katie Martin
Yes, you were very . . . Actually, that reminds me.

Ethan Wu
That was rather mean. (Laughter) I apologise.

Katie Martin
You were very mean to me about being smacked off my bike by a van. Anyway, I’m back. Cycling is good. If I have any more accidents, that’s it. It’s over.

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Ethan Wu
All right. Well, Katie, we wish you safe travels now and indefinitely into the future. And, listeners, we wish you safe travels. If you have bike route recommendations, let me know. ethan.wu@ft.com All right, Katie, thanks for being here. We’ll have you back next week. And listeners, we’re back in your feed on Thursday with another episode of Unhedged. We’ll catch you then.

Unhedged is produced by Jake Harper and edited by Briyant Urstadt. Our executive producer is Jacob Goldstein. We had additional help from Topher Forhecz. Cheryl Brumley is the FT’s global head of audio. Special thanks to Laura Clarke, Alastair Mackie, Gretta Cohn and Natalie Sadler. FT premium subscribers can get the Unhedged newsletter for free. A 30-day free trial is available to everyone else. Just go to ft.com/unhedgedoffer. I’m Ethan Wu. Thanks for listening.

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