In recent news, Elon Musk's net worth took a hit when a judge in Delaware ruled that a compensation package he received in 2018 was excessive and unfair to shareholders. While the financial implications of this decision are being widely discussed, there is another important aspect of the story that deserves attention - the role of passive funds in instigating this drama.
When Tesla was announced to be included in the S&P 500 index in November 2020, it caused a frenzy among active investors who saw an opportunity to front run the looming passive bid. In an article for Forbes at the time, I questioned whether S&P 500 investors really wanted to buy Tesla after it had already experienced a significant surge in value. However, despite the concerns raised, passive investing giants like Vanguard and Blackrock went ahead and purchased Tesla shares, as they typically follow a market-cap-weighted investment process that emphasizes chasing stocks with the highest momentum.
Interestingly, since the publication of that article, Tesla shares have declined by 4 percent, underperforming the overall positive return of the S&P 500 which saw a 40 percent increase. In contrast, the S&P 500 Energy sector has surged by 146 percent. While long-term Tesla shareholders have still enjoyed substantial profits, the passive investors who engaged in the speculative frenzy of late 2020 have not fared as well.
It's worth noting that despite benefiting from Tesla's remarkable rally and becoming the richest person in the world, Musk himself seems to be skeptical of passive funds. During Tesla's recent conference call, he likened proxy advisor Institutional Shareholder Services (ISS) to the extremist group ISIS, expressing concerns about the growing power of index funds and their impact on corporate governance. Musk's comments may have initially been dismissed as self-serving, given his request for a compensation plan that would increase his stake in Tesla, but it's worth considering the warning issued by the late Vanguard founder, John Bogle.
Bogle, often hailed as the godfather of passive investing, expressed concerns about the increasing dominance of a few institutional investors who could potentially hold voting control over major US corporations, thereby influencing financial markets, corporate governance, and regulations. Musk's worries about passive ownership and the influence of corporate governance advisors may not be entirely unfounded.
At present, the share of US equity ETFs and mutual funds that are passively managed stands at 60 percent and is continuing to rise. If this trend continues unchecked, it is likely to have a significant impact on voting rights in the future. Corporate governance advisors such as ISS and Glass Lewis, who provide guidance on shareholder votes at some of the world's largest companies, may become increasingly powerful given their association with passive funds.
Moreover, the rise of market-cap-weighted passive funds has additional consequences beyond corporate governance concerns. As our financial system becomes progressively more passive in nature, it systematically distorts the valuation profiles of major companies, making them less safe as long-term investments. These funds tend to invest based on company size, resulting in the largest companies receiving a disproportionate amount of capital. While this benefits the biggest companies when passive flows are positive, it also means that when these stocks become highly overpriced compared to their earnings potential, it can lead to inflated valuations and potential downturns when equity flows reverse.
For instance, the Magnificent 7 stocks, including Apple, Microsoft, Tesla, and NVIDIA, experienced tremendous growth in 2023, but also suffered significant losses when financial conditions tightened. This distortionary effect on the stock market and economy is supported by mounting evidence, suggesting that market-cap-weighted passive investing is causing unhealthy disruptions.
Passive investing's impact on wealth inequality is also a cause for concern. Passive funds tend to favor the largest and richest companies, which further enriches the wealthiest individuals who own and run these corporations. This exacerbates the already widening global wealth gap, as seen in the annual report from Oxfam. While a few billionaires have seen their fortunes double since 2020, nearly five billion people have become poorer, highlighting the flaws in this system.
Economies thrive when economic gains are broadly distributed, as it increases the velocity of capital and benefits everyone. Conversely, concentrated wealth distribution creates social tension and unrest. Passive investing, designed to be cost-effective and accessible to all, now seems to be disproportionately favoring the top companies and individuals, exacerbating wealth inequality rather than addressing it.
Passive investing is a story with multiple narratives. Some argue that it democratizes investing by reducing fees and barriers, benefitting the average investor. Others believe that it pollutes the free market signals that traditionally guide capital allocation towards the most promising opportunities. While different perspectives exist, one thing is clear: passive investing has reached a point where its consequences warrant careful consideration.
John Bogle himself recognized that there is a limit to how high passive ownership can go without negative repercussions. It is imperative to recognize that passive investors rely on the active decisions made by others. Like a classroom where students increasingly rely on copying rather than studying, if the trend continues, it will impair our markets and economy.
In our pursuit of a balanced and prosperous society, we must acknowledge the potential risks associated with the continued growth of passive investing. Balancing the benefits of accessibility and cost reduction with the need for active decision-making and real market signals is crucial for the long-term health of our financial system, economy, and society as a whole.
