In last week’s article, Why You Should Understand the Market’s Upward Momentum and What’s Going to Stop It, I explained how following market benchmarks is easier than following individual stocks. That’s because “big-picture drivers” (that are easy to follow) impact investor psychology and market direction.
Those drivers are:
- What the market is doing
- Interest rates and central bank policies
- The economy
- Alternative investment opportunities
- Risk and reward
I explained that “momentum isn’t last on that shortlist because it’s the least important big-picture item. It’s last because everything before it determines momentum…and when it’s hot, it becomes its own driver.”
And I also teased what this article’s going to reveal: “There’s another piece to the momentum picture, a big-picture momentum driver all its own, that’s been an engine of momentum, which I’ll get into right here next week.”
So, what’s the secret?
The hardly ever talked about big-picture momentum driver is the passive investing trend.
Here’s what it is, how it works, why it’s working so well, and what could end it.
What Passive Investing Is and How it Works
Passive investing is simply investing in “the market” or an index product that tracks a market, or any sub-set of any market, as opposed to investing in an “active” product, like a mutual fund or a hedge fund, where managers actively construct portfolios to generate returns.
All active managers and actively managed funds are “benchmarked” against an index or some standardized measure of what they’re supposed to be investing in.
For the most part, institutional managers actively managing mutual funds, ETFs, and hedge funds are benchmarked against the S&P 500.
In other words, the S&P 500 is considered by professionals to be the “the market” against which their performance should be measured.
The problem is it’s hard for active managers to beat the market.
Why It’s Working so Well
According to S&P Dow Jones Indices SPIVA research, 92% to 95% of active managers failed to beat the market over a 15-year period.
Investors have become increasingly aware of that fact and have been taking capital away from active managers and plowing money into index-tracking mutual funds and ETFs.
In 2017 investors put a record $663 billion into passive investment products.
In 2018 they pulled $301 billion from actively managed funds and parked $458 billion into index products.
Even during the last quarter of 2018, when markets got hammered from October through Christmas Eve (thanks to the Fed raising rates three times), investors kept putting money into passive funds.
In December of 2018, the scariest month of the year for stock market participants, investors pulled $143 billion out of actively managed funds. That’s the steepest withdrawal of money ever in a month.
But they bought $60 billion worth of index funds!
By far, most passive investing capital goes into whole market benchmark index funds, with the S&P 500 or knockoff indexes that closely track the S&P 500, being the most popular.
The momentum lever at full tilt.
What Could End It
As “the market” goes up, investors see that, pull capital from active managers, and more importantly, they take sidelined money, join the passive investing trend, and buy index funds.
Their buying of benchmark indexes naturally raises price levels of those indexes – meaning “the market.”
That brings more money off the sidelines into rising markets, fueling momentum.
Wash, rinse, repeat.
The upward momentum equity markets have been enjoying almost becomes self-perpetuating.
That’s why I’ve been so bullish on the market.
That’s why, as Stuart Varney, host of Fox Business News’ Varney & Co. (the number one rated and watched financial news program on television) says, “The market just looks like it wants to go up.”
He’s right. Now you know why it’s going up.
It’s all good until it isn’t.
That means if money stops flowing into passive investment vehicles, and worse, if passive investors become active and start selling their index funds, markets will be in serious trouble.
That’s not happening.
On Friday I’ll tell you what could happen, how it could happen, and how bad things could get if passive investors become active.