In NVDIA, we do not trust...

In 1991, Bill Sharpe published a landmark paper in finance entitled "The Arithmetic of Active Management." In this paper, he hypothesized that an investor would be better off with a passive investment strategy that bought the whole market, reducing fees and taxes due to reduced transactions. By avoiding paying 1-2% fees and consistently achieving market returns, an investor could potentially outperform actively managed funds in the long run. The immediate problem with this strategy was that it was correct and worked too well. At the time of its publication, only about 1-2% of assets were passively managed in the US stock market. Today, that number has increased to somewhere between 45 and 50%.

In 1998, I was fortunate to land an internship at a local stock brokerage where the branch manager and one of the brokers became lifelong mentors. Among the many lessons I learned, one stands out as particularly important to our discussion today. I learned that when investing other people's money, relative performance is crucial. It is essential to ensure that the securities selected for their account move with the broad market, both upwards and downwards. Your clients should see returns when their neighbors are making money and it is okay to experience losses when their neighbors are also losing money. The challenge for money managers is that clients can withdraw their funds at any time. They may have constructed a portfolio that will vastly outperform over the next two decades. However, if it significantly underperforms in the initial years of this 20-year period, clients may, and frequently do, withdraw their funds before this exceptional portfolio has a chance to prove its worth. Warren Buffett’s solution to this problem was utilizing a closed-end fund like Berkshire Hathaway, which allowed him to invest without interruptions from investors trying to exit, enabling him to make investment decisions independently and avoid overpaying for securities in overvalued markets. This luxury is not readily available to the average stockbroker or mutual fund manager, especially in today's digital world where transferring funds and changing investments can be accomplished through a smartphone within minutes. Investors no longer need to visit a physical location to terminate their manager and switch to an outperforming passive fund, placing money managers in a precarious position.

The solution to this dilemma is closet indexing, a practice that predates Bill Sharpe and passive investing. Stockbrokers and fund managers benchmarked against indices such as the S&P 500 have been engaging in this practice for some time. Understanding that they cannot deviate far from the index, managers essentially buy the index or engage in closet indexing. This approach involves constructing a portfolio that closely mirrors the movements of the benchmark index, such as the S&P 500, while selectively overweighting stocks they have high confidence in. This small portion of the portfolio represents their efforts to beat the market by making strategic investments. However, since they cannot deviate significantly from the index, the bulk of the portfolio comprises index-mimicking holdings to ensure alignment with market movements.

An important factor to consider in this context is the market capitalization-weighted nature of indexes, which can pose challenges when combined with passive investing. The S&P 500, for instance, is not equally weighted among its 500 stocks; rather, it is weighted based on the size of the companies, meaning that larger stocks have a more significant impact on index returns. As an illustration, Apple Inc. has a higher weight in the index than the combined bottom 200 companies in the S&P 500. Consequently, if Apple's stock price rises while the prices of the other 200 companies decline, Apple's performance can offset the losses of the smaller companies. Due to these dynamics, investment managers implementing closet indexing strategies need to prioritize owning the larger companies in the index to ensure their portfolios track with the S&P 500. Since there are no direct substitutes for certain mega-cap stocks like Apple, investment managers face significant career risk if they omit such stocks from their portfolios. In essence, the incentives within the industry drive managers towards holding these prominent stocks, aligning with Charlie Munger's philosophy that incentives dictate outcomes.

The cumulative effect of passive investing alongside the practice of closet indexing has led to the concentration of market capitalization among the largest stocks in the index, often referred to as the "mag 7." These seven largest stocks have seen their weight within the index nearly triple over the last decade, impacting market dynamics significantly.

When passive investing initially emerged, one assumption, whether explicitly stated or not, was that its transactions would not influence market prices. The belief was that with ample liquidity, particularly in larger stocks, the buying and selling activities associated with passive strategies would not sway prices. However, in 2022, an intriguing academic paper emerged, titled "In Search of the Origins of Financial Fluctuations: The Inelastic Markets Hypothesis" by Xavier Gabaix and Ralph S.J. Koijen (May 12, 2022). The paper introduced research suggesting that for every $1 of new money invested in the market, this could potentially add $5 to the market capitalization of a stock. Next week, we will delve deeper into the potential implications this phenomenon holds for the markets. As I write this, the world's largest stock, NVDIA, is down by 17% in a single day. And yes, I do believe passive is playing a significant role in this volatility. Stay safe out there!