Is Passive Investment Killing Value?

Growth and value are two fundamental styles of stock-picking that for years have faced off in a contest for supremacy. To put it simply, growth investors seek to invest in companies that have been posting above-average earnings growth, while value investors look for stocks that appear to be out of favour and have been mispriced by the market. While in combination the two styles are very much complementary, of late the plaudits have all gone in favour of the growth investors. One contributing factor could be the rapid rise in popularity of passive investment and exchange-traded funds (ETFs).

For years, active managers have undertaken both fundamental and technical analysis across the range of companies determining the appropriate times to buy and sell. Passive managers, meanwhile, have alternatively invested broadly across the index without any analysis capturing both the best and worst of the investment universe.

There has been a meteoric rise in the popularity of ETFs since the global financial crisis, with some analysts suspecting passive investment now controls as much as half the stock market. Investors have been drawn to the lower management fees of ETFs and their success in tracking rising indexes. Over the same period, active managers have charged higher fees and performance has been hit and miss. However, it is possible the inflows into ETFs may be having a much greater influence on capital markets.

Metaphorically, imagine a field of sheep (passive investors) being herded by a pack of sheepdogs (active investors). If the stock price or sheep run too high the sheepdogs will sell, herding the stock the other way until the price becomes attractive again, at which point sheepdogs will herd the sheep back the other way. Now, imagine we double the number of sheep or make them twice as big. What effect could this be having? Could the sheer size of passive investment have the potential to overpower active investors?

While it may still be too early to assess any ramifications, in a rising equity market the inflow of passive investment certainly favours the characteristics of a growth investor. Typically, a growth investor will target stock with strong growth and share price momentum, which will not only be supported by their investment but additional flows into ETFs, encouraging further momentum and share price appreciation.

Alternatively, a value investor will look to invest in a good company at a low valuation, seeking businesses and sectors that have been mispriced by the broader market.

Most value managers have suggested it has been difficult to find value in recent times. Even value guru Warren Buffett has recently preferred to buy back his own stock rather than re-investing back into the market, stating even he is having difficulty finding value.

Although the drop-off in value opportunities isn’t entirely a result of ETF inflows, if you dial down to a more technical level, additional investment into the passive space does suggest demand in stocks that would otherwise go unloved. As a result, falling equities may pick up more support than they typically would have, possibly denying value managers the opportunity to enter at their desired valuations.

We must also consider that since the global financial crisis we have seen a tremendously low volatility run in equity markets, with the only significant pullback occurring in the fourth quarter of 2018 – a trend that also has favoured both passive and growth strategies. It begs the question: if we were to see a turn in investment markets, would that also coincide with a revival of value investing?