MW The 3 biggest passive-investing myths Goldman Sachs says investors need to get over
By Joseph Adinolfi
Passive investing hasn't distorted valuations - nor has it been a major driver of the increasingly concentrated market
Over the years, passive investing has been accused of being "worse than Marxism," and of leaving markets "fundamentally broken."
But is Wall Street's constant carping about a trend that has dramatically lowered the cost of investing (while sapping some of the asset-management industry's fee-based revenue) really justified? Or are active managers simply struggling with a case of sour grapes, considering how few of them manage to outperform indexes like the S&P 500, which retirees can gain exposure to via low-cost index funds like the SPDR S&P 500 ETF SPY or the Vanguard S&P 500 ETF VOO?
The latest data from S&P Dow Jones Indices, shared with MarketWatch last week, found that 57% of actively managed funds benchmarked to the S&P 500 SPX underperformed the index during the first half of 2024 - a slight improvement over the 60% that underperformed in 2023.
As money continues to pour into passive funds while simultaneously flowing out of their actively managed rivals, a team of equity strategists at Goldman Sachs Group $(GS)$ led by David Kostin, the bank's chief U.S. equity strategist, decided to delve into some of the more popular criticisms of passive management. They found that, in every case, these concerns were based on misconceptions that weren't supported by the data.
It is important for investors to understand the pros and cons of passive investing, not only for their own portfolios, but for the broader market. After all, according to Goldman, some $2.8 trillion has flowed into passive funds over the past decade, compared with $3 trillion in cumulative outflows from active funds.
Not every corner of the active-management business is shrinking: Actively managed ETFs have grown over the past decade, and a boom in new active ETFs has helped attract nearly $150 billion in inflows between the start of the year and September, according to Morningstar data.
Passively managed equity funds first eclipsed their actively managed peers back in 2021, according to Morningstar. Since then, their fortunes have continued to diverge.
Here are a few of the market myths Goldman busted in a client report recently shared with MarketWatch.
Myth: Passive investing helped fuel the rise of the 'Magnificent Seven'
Members of the group of tech stocks known as the Magnificent Seven - particularly artificial-intelligence darling Nvidia Corp. $(NVDA)$ - have driven an outsize share of the gains for the S&P 500 and Nasdaq Composite over the past two years.
Their rise has fueled an almost-unprecedented increase in index concentration that some, including the team at Goldman Sachs, have argued could weigh on returns going forward.
See: Wall Street is worried stocks might be on the cusp of a 'lost decade'
Some have blamed passive investors for unwittingly exacerbating this trend.
But according to Goldman's analysis, passive managers' ownership of Magnificent Seven stocks is actually smaller than it is for the average S&P 500 stock, which cuts against the notion that it has contributed to the outperformance.
As the chart above shows, current passive ownership for the Magnificent Seven stands at 22%, compared with 24% for the average S&P 500 stock and 25% for shares of the other 493 companies included in the index.
Myth: Passive investing distorts stock-market valuations
This is perhaps one of the most popular criticisms of the growth of passive management. The reason is understandable: Equity valuations have trended higher over the past decade, coinciding with the rise of passive investing.
Since at least early 2018, the forward price-to-earnings ratio of the S&P 500 has risen, while the total assets under management of passively managed equity ETFs has increased, according to data from FactSet and Morningstar.
But as statisticians like to remind us, there is a difference between correlation and causation.
Using a regression analysis, the Goldman team found that fundamental factors like expectations for earnings growth and corporate profit margins exerted far greater influence over large-cap stocks' valuations than did the degree of passive ownership.
"For stock pickers the share of passive ownership of a company is much less important for valuation multiples than fundamental attributes. Stocks with the highest share of passive ownership haven't consistently outperformed stocks with the lowest share," the Goldman team said.
Myth: Passive investing causes stocks to move in lockstep
This claim was fairly easy for the Goldman team to debunk. Intuitively, it is tempting to assume that rising passive ownership has caused stocks in the S&P 500 to move in lockstep.
But since the mid-1990s, the degree of correlation within the index has been pretty volatile.
What's more, there are wide gaps between the percentage of passive ownership among different stocks in the S&P 500. Passive ownership stood at 28% for a plurality of stocks within the index, while some had passive-ownership levels as high as 40%.
Real-estate stocks currently have the highest level of passive ownership among the S&P 500's 11 sectors, at above 30%.
These stocks have lagged behind the S&P 500 in 2024. Since the start of the year, the Real Estate Select Sector SPDR ETF XLRE has gained 8.3%, compared with a nearly 21% advance for the S&P 500, FactSet data show.
Stocks traded higher on Tuesday, with the S&P 500 up nearly 1% in recent trading, while the Nasdaq Composite COMP gained 1.2%. The Dow Jones Industrial Average DJIA was up by more than 300 points, or 0.7%.
-Joseph Adinolfi
This content was created by MarketWatch, which is operated by Dow Jones & Co. MarketWatch is published independently from Dow Jones Newswires and The Wall Street Journal.
(END) Dow Jones Newswires
November 05, 2024 12:34 ET (17:34 GMT)
Copyright (c) 2024 Dow Jones & Company, Inc.
Comments