{"text":[[{"start":6.15,"text":"Ten orbits of the sun ago, Sanford C Bernstein wrote a report called “The Silent Road to Serfdom: Why Passive Investing is Worse than Marxism”. I was in the research game back then too and I was jealous as hell of the title."}],[{"start":19.5,"text":"Bankers and money managers are called a lot of things, but rarely commies. In the mid-2010s, however, there was a backlash against the rise of index funds. They were accused of undermining free markets and the efficient allocation of capital."}],[{"start":34.9,"text":"Needless to say, most of the squawking came from stock pickers and those — such as Bernstein — who depend on them. Passive strategies were eating everyone’s lunch. Active US equity funds, for example, had not had net annual inflows for more than a decade."}],[{"start":51.25,"text":"It was a compelling argument, too. The huge inflows into the likes of ETFs are forced to buy whatever’s in an index, rather than usefully sorting the winners from losers like a portfolio manager or analyst does."}],[{"start":65.2,"text":"This blind purchasing of stocks could be seen in a downtrend in the dispersion of returns. Simply put, the performance gap between the best and worst companies was narrowing. Dumb money rewarded failure and spurned excellence."}],[{"start":80.95,"text":"A good ETF is a dead ETF, therefore. Such rallying cries didn’t last long, however, as we grew distracted by Brexit, trade wars, a repo crisis and then Covid. But SpaceX going public has suddenly got people shouting at passive funds again."}],[{"start":96.8,"text":"Elon achieved a $135 per share valuation only because passive funds are forced to buy whatever is shoved down their throats. No wonder Nasdaq and the S&P 500 were pressed to include the stock in their indices faster than usual!"}],[{"start":111.14999999999999,"text":"This line of thinking also makes it a no-brainer to buy Anthropic and OpenAI when they list. Their prices will be supported no matter what. With index strategies owning at least a quarter of US large-cap shares, you can’t lose."}],[{"start":125.64999999999999,"text":"Except that you can. And that’s because the arguments above are hogwash. Passive investing didn’t lower the dispersion of returns — the latter gave rise to the former. What is more, no matter how large index funds become, price discovery is always the preserve of active investors."}],[{"start":142.75,"text":"A Marxist conspiracy this is not. Think about it logically. If ETFs are totally price inelastic and eclipse active managers for size, stocks would immediately trade at infinity or zero. That’s not how it works."}],[{"start":155.6,"text":"Passive funds buy and sell shares so that their holdings replicate a benchmark. At best, therefore, they can only move an index up and down — and if their inflows come from the outflows from active funds, not even that."}],[{"start":168.54999999999998,"text":"As always in markets, it’s the marginal buyer and seller that count. Imagine the Nasdaq has three companies: SpaceX, Anthropic and OpenAI. And there are only two active managers left in the world and one passive one, called Vanshares. "}],[{"start":185.14999999999998,"text":"If a zillion dollars flow into the ETF, shares have to be bought from someone. The two active funds keep raising their prices until levels are reached at which they are prepared to trade with each other, based on their respective outlooks for all three companies."}],[{"start":199.99999999999997,"text":"They determine the relative values no matter how big the passive buying is — Vanshares is always a price taker. Sure, the index goes up. But that would also have been the case if millions of stock pickers decided to throw money at SpaceX, Anthropic and OpenAI."}],[{"start":217.24999999999997,"text":"Of course, just because active investors call the shots doesn’t mean they make the right choices. Should the price-to-book ratio of Nvidia really be triple Walmart’s? Time will tell. And sometimes it’s easier to tell in advance, sometimes harder."}],[{"start":231.49999999999997,"text":"This brings us back to returns dispersion. It follows that when it’s elevated, the scope for outperforming an index via stock selection is greater. By contrast, the potential rewards from analysing companies are less when returns are concentrated."}],[{"start":246.99999999999997,"text":"History shows dispersion to be cyclical — for reasons I won’t go into here. At the moment, levels are highish, which active managers are jumping on as a reason for you to give them your money rather than putting it in an ETF."}],[{"start":260.54999999999995,"text":"Sounds logical, except for one thing. Sure, it is easier to generate alpha (the difference between your performance and the index) when stock returns are all over the place. But it’s easier to underperform as well. It’s safer (and cheaper) to go passive regardless."}],[{"start":278.24999999999994,"text":"Clever clogs readers may already have run off to begin the process of listing their own company having absorbed the above. Why not sell a single share to your mate (0.0000001 per cent of the shares available) for a dollar, thereby arriving at a $1bn valuation. That gets you into an index and thus bought by passive funds."}],[{"start":300.59999999999997,"text":"Easy money, right? It would be if indices gave debutants a full weighting based on their market capitalisations (price times total share count). Most don’t. Instead, they “float adjust” the weightings. If you only sell a fifth of your shares, your index weighting is reduced accordingly."}],[{"start":317.15,"text":"Or at least that’s what most indices do. The Nasdaq Composite, by contrast, includes stocks at their full whack, even if only a small percentage of shares are trading. There is a bit of confusion around this as the Nasdaq-100 — the more grown-up index — does float-adjust its weightings, but not one for one."}],[{"start":335.95,"text":"It applies a cap of three times. For example, if you sold 5 per cent of your shares — roughly as SpaceX did — your float-adjusted size in the Nasdaq-100 index would be 85 per cent lower than the weighting in the Nasdaq Composite, rather than 95 per cent lower."}],[{"start":352.55,"text":"Many investors have said this makes a mockery of the index. I’m not bothered. It’s a free world and every index is contrived. Go invent your own. And just because passive funds have to buy a stock, it doesn’t mean they are setting the price."}],[{"start":368.95,"text":"The author is a former portfolio manager. Email: [email protected]"}],[{"start":null,"text":"Vanguard FTSE 100 ETF (GBP)"}],[{"start":null,"text":"iShares MSCI EM Asia ETF (USD)"}],[{"start":null,"text":"Vanguard FTSE Japan ETF (USD)"}],[{"start":null,"text":"Vanguard S&P 500 ETF (USD)"}],[{"start":null,"text":"BlackRock Latin American Ords"}],[{"start":null,"text":"4.5% Treasury Gilt 2034"}],[{"start":381.09999999999997,"text":""}]],"url":"https://audio.ftcn.net.cn/album/a_1781872058_1572.mp3"}