‘Magical’ Efficient-Market Theory Rebuked in Era of Passive Investing
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‘Magical’ Efficient-Market Theory Rebuked in Era of Passive Investing
Justina Lee
5 min read
(Bloomberg) -- At first blush, stock trading this week is hardly a paragon of the market-efficiency theory, an oft-romanticized idea in Economics 101. After all, big equity gauges plunged on Monday, spurred by fears of an AI model released a week earlier, before swiftly rebounding.
A fresh academic paper suggests the rise of passive investing may be fueling these kind of fragile market moves.
According to a study to be published in the prestigious American Economic Review, evidence is building that active managers are slow to scoop up stocks en masse when prices move away from their intrinsic worth. Thanks to this lethargic trading behavior and the relentless boom in benchmark-tracking index funds, the impact of each trade on prices gets amplified, explaining how sell orders, like on Monday perhaps, can induce broader equity gyrations.
As a result, the financial landscape is proving less dynamic and more volatile in the era of Big Passive, according to authors at the UCLA Anderson School of Management, the Stockholm School of Economics and the University of Minnesota Carlson School of Management.
“This efficient markets view is a little bit of what I would call magical thinking,” said co-author Valentin Haddad, an associate finance professor at UCLA. “If a fraction of investors become passive, and the remaining active ones don’t change what they do, prices will become less stable.”
It’s far from a purely academic debate. A less efficient market risks misallocating capital across Corporate America, while undercuting investing strategies that bet on market fundamentals.
Echoing warnings about “broken markets” from the likes of Greenlight Capital’s David Einhorn, the study is the latest critique of the idea that stock pickers — long lionized as Wall Street’s rational opportunist — will instinctively correct market anomalies. AQR Capital Management’s Cliff Asness and Apollo Global Management’s Torsten Slok have both cited the study as one lens into how the passive-investing boom might be reshaping markets.
Combing through 13F filings and individual stock data, the paper examines how aggressively active managers trade a stock when prices change and more of it is owned by index funds, which typically buy shares in proportion to their capitalization — with scant consideration to valuations.
The bad news is that investors as a whole are judged to be 11% less sensitive these days to shifts in prices, a measure known as demand elasticity, thanks to the rise of passive over the last 20 years. Put another way, the active cohort is increasingly declining to snap up a stock in droves when it’s, say, trading at $10 even when they reckon it’s ultimately worth $11.
“Aggressivity or elasticity is what makes sure that prices stay stable or close to fundamentals,” said Haddad.
The paper is far from consensus in both academia and Wall Street. While Apollo and Citadel have also voiced concerns over the impact of passive, Goldman Sachs Group Inc. and Citigroup Inc. analysts have recently argued the other side.
While stock pickers do trade more when they are surrounded by sleepy index funds, they don’t do so nearly enough to make up for the latter’s growing dominance, according to the paper by Haddad, Paul Huebner and Erik Loualiche. All this risks making the equity market less liquid and less tied to fundamental information. Einhorn said last year markets are now “broken,” owing to the thinning ranks of investors like him focused on long-term corporate value.
The paper suggests a few reasons why investors aren’t being more aggressive. Many managers are constrained by their mandates or turnover limits, with some even being outright benchmark-huggers. As a result, they may be even more reluctant to tinker with their biggest holdings.
The conversion to passive has continued unabated since the paper was posted online in 2021. In the US, stock index funds raked in $585 billion last year, marking the 11th straight year of passive inflows and active outflows, data compiled by Bloomberg Intelligence show.
To be sure, the paper found too much noise in the data to definitively conclude that the world’s biggest equity market is less efficient – an inherently hard proposition to measure. Another study published in 2022 found little impact on that from the rise of passive.
Still, the paper by Haddad, Huebner and Loualiche has found traction among those that fear the passive juggernaut can easily destabilize markets.
Michael Green, one of the sector’s loudest critics, has seized on the economists’ finding that larger stocks have even lower elasticity — meaning the bigger the stock, the less investor demand is being swayed by the change in price. So every trade has the potential to move prices even more — as seen in Monday’s moves.
Large caps are even “more prone to wide swings in dollar value that makes it very difficult for managers to correct mis-valuation,” Green said.
Haddad is unsure himself about the broader takeaways from his research. While most individual investors probably benefit from index funds, the paper suggests their popularity is starting to affect markets’ role in directing resources.
“If the price drops for non-fundamental reason, somebody’s going to come in and buy and that’s going to stabilize prices – that’s the basic idea of how prices stay stable and close to fundamentals in finance,” he said. “The less of this elasticity you have, the less the market is going to absorb this because passive don’t react to anything.”
