A number of prominent market commentators (see Mike Green at Logica Funds or Vincent Deluard of StoneX) have noticed that the growing passive investment target date fund complex has fundamentally changed how the financial markets work. While active investors invest according to a valuation metric, passive investors simply allocate capital without any reference to valuations. In recent years passive investors have steadily increased in influence and appear to be on an unstoppable march towards dominance.
A market dominated by active investors is mean reverting. When the market is too “cheap” then the active investors buy, and when it is too “expensive” then the active investors sell. These active investors – such as traditional long/short asset managers or any disciple of Benjamin Graham – will have different views of what valuations are, but they will agree that valuations matter.
On the other hand, passive investors don’t care about valuations. Their instructions are to invest the money given to them, regardless of price. For example, a typical 401k plan will receive a contribution at each pay period and invest it in the market according to a preset allocations, such as 50% in equities and 50% in bonds. That investment occurs regardless of any valuation metric. A market dominated by passive investors thus trends higher.
Passive investment vehicles have steadily grown in recent years as corporations set-up their employees with target date retirement funds. This has been providing a steady bid in the market, likely contributing to the slow grind upwards seen in major U.S. equity indices. But how influential are those funds?Continue reading