The rise of passive investing is distorting price signals and pushing up the volatility of the US stock market, according to academic research.

The analysis raises fresh questions about the widespread adoption of index-based investing, a trend that has allowed investors to save billions of dollars a year in the shape of lower fees — seemingly without hurting returns.

“Markets [have] become less efficient from the rise in passive investing,” said Valentin Haddad, associate professor of finance at UCLA Anderson School of Management.

Haddad and two other US academics examined trades by institutional investors and found that the rise in passive investors’ share of the market over the past 20 years “has led to substantially more inelastic aggregate demand curves for individual stocks, by 15 per cent”.

Passive investors have a “demand elasticity” of zero, that is they do not buy more of a stock if it becomes cheaper or less as it becomes more expensive.

An increase in the share of passive investment thus pushes the market’s aggregate elasticity down.

Market theory suggests this should not really matter — that when a trader is surrounded by less aggressive traders they themselves become more aggressive, cancelling out the effect and maintaining the market’s competitiveness.

But the academics found this “pass-through” was only about 0.6, meaning that almost half of the decline in the proportion of active investors translates into a reduction in overall demand elasticity.

“Passive money is not paying attention to any information. Efficient market hypothesis proponents say it’s not a big deal because others will come in,’ said Haddad, who co-authored the paper, How Competitive is the Stock Market?, with Paul Huebner and Erik Loualiche.

“But not enough people are showing up to trade. You have less information in the market, less aggressive trading, less accurate prices and a more volatile market,” he said.

He contended that even the rise in market turnover caused by the emergence of algorithm-driven high-frequency traders could not compensate for the decline in market efficiency caused by the reduction in more fundamentally driven active investors.

“HFT does offset it to some extent. It makes prices liquid but it doesn’t help on the longer-term horizon. Nobody is there to take a long view,” he said.

Felix Goltz, research director at Scientific Beta, a data provider, said the paper added to the growing body of research that shows the impact that passive investing has on markets is “huge”.

Goltz cited the “price effect” — in essence another phrase for an inelastic demand curve — that occurs when a stock enters an index and passive investors have to buy it.

“Even if the price goes up only marginally because of these investors you can make the case that rational investors should not buy the stock because there are alternatives, there are perfect substitutes, so there can’t be any impact on the price of such a stock. But there is evidence that there is an effect,” he said.

“These effects have been documented with the S&P 500: a stock increases its price when it enters the index and the opposite happens if it is kicked out.”

In the case outlined by Haddad et al, Goltz said investors were buying a stock “even though the price has gone up”, so demand is more inelastic and “you can have additional volatility from shifts in demand”.

He said the rise of passive funds investing on the basis of environmental, social and governance principles could exacerbate the problem.

With ESG, “the preference [to buy stocks in the index] is becoming stronger”, Goltz said. “People think [companies] are doing something harmful to society if they are not in the index so they care more about whether a stock is included.”

As a result, “demand should be more inelastic for stocks included in ESG benchmarks. That should lead to higher prices for these stocks,” Goltz added. Consequently they “would have lower long-term returns. If you don’t care about these [ESG] tastes, you can buy stocks that have higher long-term returns.”

Another academic, who declined to be named, said the findings were “not necessarily surprising”, given the size of the big index managers such as BlackRock, Vanguard and State Street Global Advisors, and how much they have absorbed of the float of public companies.

However, he said that “there is no reliable evidence yet that indexing systematically hampers the price discovery of stocks”.

Indeed, on balance, he said indexing may aid price discovery by increasing the supply of lendable shares and thus enabling short selling.

While accepting that the growth of passive investing has provided benefits to investors, Haddad believed pricing would be more accurate and volatility lower if more active traders were encouraged into the market. “There is still a very healthy [active] financial sector but it’s shrinking and we need some of these guys,” he said.

Have you dared to look at your investment portfolio recently?

I have sympathy for “armchair investors” who would rather hide under a cushion than see how badly their Isa or Sipp has been clobbered since the start of this year. However, some research about active funds made me sit up and take notice this week.

In the first six months of this year, nearly two-thirds (60 per cent) of actively-managed equity funds have fallen further than the market.

Yes, you read that right. Actively-managed funds — where you pay extra for a team of well-remunerated fund managers to cherry pick stocks they think will outperform — have actually underperformed cheaper passive funds that simply track the nearest comparable index.

“In a year where markets have been falling and longstanding trends have gone into reverse, you might have expected active fund managers to perform better,” says investment analyst Laith Khalaf, author of AJ Bell’s “Manager versus Machine” report.

The report, which examines the performance of actively managed equity funds in seven key Investment Association sectors compared with the average passive fund performance, shows the opposite is true.

Active performance has been particularly miserable in the UK, where only 12 per cent of active funds managed to outperform a passive alternative.

AJ Bell found the average UK active fund returned -13.5 per cent in the first half of 2022, compared with -4.4 per cent from the average passive fund (all of its figures are net of charges). Either way, you would have lost money — but investors in passives would have lost substantially less.

The average UK passive fund performance has been flattered by the relatively buoyant FTSE 100, which is heavily skewed towards big oil and commodities. By contrast, the typical UK active fund is considerably underweight in large caps. UK fund managers have a bias towards small and mid-cap stocks, which tend to have a better long-term growth story, but performance has been hit as fears of recession grow.

Active managers have had a better start to the year across the pond, where 40 per cent of US equity funds outperformed their passive equivalent — a big improvement on the 19 per cent that did so a year ago.

Again, the average return for both was negative (-11.8 per cent for passive versus -13.3 per cent for active) but the absence of big tech was the common theme uniting the top-performing active funds.

According to data from Morningstar, GQG Partners US Equity has notched up a cumulative return of 8.8 per cent and US equity income funds from Quilter and BNY Mellon have both achieved over 6 per cent.



Look under the bonnet of these funds, and you’ll find oil majors such as ExxonMobil, financial services companies like US Bancorp and Comerica and defence stocks like Raytheon Technologies — barely a Fang in sight!

In the UK, the two best-performing active funds (Invesco UK Opportunities and Jupiter UK Special Situations) are both heavily weighted towards BP, Shell and BAE Systems.Whether you plump for a passive or active strategy, the thought of investing in UK funds could be rather academic for investors on these shores.

We’re still more likely to be pumping our money into US equity funds, according to the latest Investment Association data, with £241mn of inflows in April compared with £689mn of outflows for UK funds in the same month — a fact reflected in the best-buy tables of UK stockbrokers.

Yet this is building up considerable concentration risk — and younger investors seem especially prone to this.

I follow several Instagram accounts where new investors offer their portfolios up for “analysis” and they often comprise entirely of single-stock investments in Tesla and Fang stocks (Facebook, Apple, Amazon, Netflix and Google).

Khalaf calculates that these tech titans have collectively plunged by 31 per cent since the start of this year — quite a lesson in why it pays to diversify.

Investors in their 20s or 30s have time on their side to make up these losses, but I’d urge them to consider the “little and often” approach to making automated monthly investments in some quality passive funds — the bedrock of my own stocks and shares Isa.

Robin Powell, founder and editor of the Evidence-Based Investor website, says he is not in the slightest surprised by the poor performance of active funds. In his forthcoming book, How to Fund the Life You Want, he argues that the investment industry rarely promotes index funds “because it makes far more money out of selling actively managed ones”.

Active funds are also far more exciting to read and write about. Investors and the financial press are suckers for stories about “star” fund managers such as Terry Smith, James Anderson, Nick Train and Neil Woodford. All have enjoyed serious outperformance in their time (some for longer than others) but recent events have shown that even the biggest beasts cannot keep beating the markets indefinitely.

So should we as investors still bother with active funds?

When you look at the average active vs passive fund performance over 10 years, the number of active funds that beat the market increases to 45 per cent. But this is still fewer than half — and Khalaf notes that this is flattered by “survivorship bias” as unsuccessful funds wind down or merge with others.

If you’re a long-term holder of Fundsmith, Baillie Gifford or Lindsell Train funds, the recent dip will have come after a long period of rip-roaring returns. However, the table shows that the success of active managers is far from uniform across different fund sectors.

While passives form the bedrock of my Isa, I have a few active “rocks” (and occasionally, a single-stock “pebble”) where I have conviction in the ability of the fund managers or management teams to outperform.

I don’t always get this right — nobody does — but I enjoy trying, my exposure is limited to a certain quota of my portfolio, and I review my fund holdings every six months or so.

“If you want to take a mix and match approach, be picky about the areas where you go active,” Khalaf suggests, noting how the US has historically been a much harder market for managers to outperform.

Even with passive funds, investors should be prepared to make an active choice. Most fund platforms now include passive funds on their “best buy” lists, but similar products often have wildly divergent fees.

AJ Bell’s research found that the most costly UK tracker fund is 21 times more expensive than the cheapest (ongoing charges ranged between 0.05 per cent and 1.06 per cent).

The machines may be lording it over the managers, but investors would still be wise to keep a watchful eye.

Claer Barrett is the FT’s consumer editor: claer.barrett@ft.com