Passive investors actively pump up market bubble

LONDON - Goodhart’s Law states that when a measure becomes a target, it ceases to be a good measure. The British economist Charles Goodhart came up with the idea in the mid-1970s when he noticed that the relationship between the money supply and consumer prices broke down once the authorities targeted monetary aggregates in order to slow inflation. Index investing appeared around the same date. As passive funds take an ever-increasing share of investment assets, Goodhart’s Law is at work again: the index no longer simply reflects the market but shapes it. With Elon Musk’s SpaceX preparing to launch a record-breaking initial public offering, that’s potentially a very serious problem.

Index investing was inspired by two somewhat different notions. One view, largely pushed by academics, held that since stock prices accurately reflect all available information, investors do not have the skill to beat the market. Another held that fund management is a zero-sum game in which one player’s outperformance relative to the index must come expense of other investors. Picking the winner was a tricky and expensive business. Exponents of both views have always maintained that investing in an index fund, whose composition is weighted by the market capitalisation of its constituents, adjusted by the number of tradable shares - the so-called free float - has no impact on prices, whether at the individual stock or market level.

Passive investment got off to a slow start but over the course of the past two-and-a-half decades has gone from strength to strength. By the end of last year, 53% of US stock market investments were held in capitalization-weighted index funds, up from 3% at the turn of the century, according to a new paper by Rob Arnott of Research Affiliates and Lillian Wu of MGI Machine Guided Investments. This success is easily explained. Investors who opted for the market index have done vastly better than those who stuck with traditional fund managers. Last year, 79% of large-cap US equity funds underperformed the S&P 500 Index. The long-term record of active managers is even worse.

Arnott and Wu, however, believe that passive investment has grown so large that it is distorting the market: “Once indexes evolved from measures of the market to mechanisms for investing their role fundamentally shifted,” they write. “The act of replication began to shape the very market it sought to describe.” When indexes are rebalanced and reconstituted, for instance, index investors automatically acquire more of those stocks that have recently risen in price and less of those that have fallen from favour. In short, index funds buy high and sell low, and reinforce recent momentum, which is the very opposite of conservative investment practice.

Low-cost tracking funds are constructed to hold more of the largest companies by market value. Arnott and Wu assert that the rising valuation premium attached to US mega cap stocks “is likely a direct consequence of cap-weighted indexing rather than a reward for superior growth.” The valuation of the largest 500 listed US companies, they say, has soared relative to the next 500 in recent years, even though the latter has experienced stronger fundamental growth.

Five years ago, Xavier Gabaix and Ralph Koijen proposed what they called the “inelastic markets hypothesis.” Contrary to modern finance theory, the stock market turns out to be highly sensitive to inflows, the economists claimed. Because the supply of stocks doesn’t immediately increase to meet additional demand, prices adjust upwards when money enters the market. In a truly efficient market, arbitrageurs would step in to return prices to their fair value. But Gabaix and Koijen claim that for various reasons the forces of market arbitrage are not up to the task. Index investment exacerbates this problem. Active managers in the United States are experiencing large outflows, amounting to nearly USD 60 billion in March and April, according to the Investment Company Institute. As a result, inflows into the market are dominated by valuation-agnostic index funds.

There’s another feature of Goodhart’s Law that is often overlooked: when a measure becomes a target it usually becomes profitable to game the target. Arnott and Wu observe that additions to index tend to enjoy significant price appreciation. As a result, “index inclusions often lock in exuberant valuations near the peak of a [speculative] narrative.” This might explain why Elon Musk has been so keen to get SpaceX - whose USD 75 billion IPO scheduled for June 12 is set to be the largest in history - into the benchmark indexes as quickly as possible.

One index provider, Standard & Poor’s, considered dropping its longstanding rule that additions to the S&P 500 benchmark must report four consecutive quarters of profitability – potentially removing a hurdle for the loss-making SpaceX. The index provider also consulted on shortening the minimum period between a company’s IPO and its inclusion in an index. On Thursday, however, S&P Dow Jones Indices announced it had decided to leave its criteria unchanged.

Nasdaq has been more obliging. The largest companies on its exchange can now join the Nasdaq 100 Index after just 15 trading days. Previously the so-called seasoning requirement stretched up to a year. Nasdaq has also dropped its minimum 10% float rule. Musk’s rockets-to-AI venture plans to float just 3-4% of its shares.

What’s more, companies with small free floats, such as SpaceX, will now be weighted in the Nasdaq index at up to three times the size of their freely traded shares. Arnott’s back-of-the-envelope calculation was that, assuming looser rules, index funds in aggregate may need to acquire up to 40% of the SpaceX shares on offer after the IPO. To avoid tracking error where the index diverges from the performance of its underlying constituents, those benchmarks that include SpaceX will have to buy at any price. That creates the conditions for a potential squeeze.

The current valuation of the US stock market is by several measures at record levels. The share of the top 10 companies in the S&P 500 is greater than ever before. Close to half the US market is exposed to the AI frenzy, according to Goldman Sachs. The largest IPO in history is set to be buoyed by price-insensitive buying from index funds. Passive investors, it seems, are playing a most active role in what increasingly looks like an epic stock market bubble.

(By Edward Chancellor; editing by Peter Thal Larsen; production by Shrabani Chakraborty)