many people say that passive index funds are driving the US Stock Market bubble. In this video, I'll go through three of the arguments and give my view on whether they're credible or not. Today's video is sponsored by Saxo, an award-winning UK investment platform. It's actually tricky to ascribe causality between people moving money into passive funds and valuations rising, and that's because a lot of people would have bought stocks anyway, whether that's via passive funds, active funds, or choosing their own stocks. So that's why the arguments are a little bit more nuanced than you might expect. But let's start off with the most obvious one. This is the one that many people naively think is the explanation. A mat argument is it index fund by more large caps than small caps. So this is the Spy fund from State Street, and it's one of the largest and oldest ETFs in the world, and it tracks the S&P 500, the US large cap stock index. And beside me here, you can see the top 10 holdings of the fund. What

you can also see beside each stock is the weight assigned to that stock as a proportion of the total assets of the fund. So, for example, Apple makes up 7% of the fund, so does Microsoft, and so on down the list. This is called market capitalization waiting, and it makes a lot of sense because if no money flows into or out of the fund, then the fund manager doesn't have to do anything to keep on tracking the index. The growth and shrinking of each of the individual stocks in terms of their market cap automatically means they match the index weight. It's only if money flows into the fund or out of the fund that it has to do any buying or selling. But what's always the case is that the holdings of the fund are dominated by, say, the top 10 holdings. So if we look at the waiting in a spreadsheet, you can see how much of the index is made up by the top 10 holdings. So if we drag down to the 10th stock here, that makes up 36% of the

index a third of the index, and at the moment, it's very concentrated. The reason behind that is that Mega cap growth stocks have simply been surging for a long period of time in the US. Also, recently, there's been a narrative about Ai, and any AI-related company has certainly surged in terms of value. In fact, if we select the top 20 seven names in the S&P 500, they make up about half of the index. Such that if we scoot down to the bottom of the index, you can see that companies like Etsy, companies like Hasbro, have such tiny weights such that they're almost rounding errors. They just don't have much impact on the index at all. So, for example, if we look at the weight of Apple in the index and Broadcom, so that's number one and number 10 in the list, Apple has a 4 and a half times higher waiting than Broadcom. That's because its market capitalization is $3.6 trillion versus just 800 billion for Broadcom. So now let's imagine that some

money flows into this spy fund, and it has to go out and buy some of these stocks. The key point here is that, yes, in dollar terms, it has to buy a lot more stock of Apple than it does of Broadcom. If it buys a billion dollars of Broadcom, it would have to buy $4.2 billion dollars of Apple. And that's to maintain the market waiting. However, as a proportion of the outstanding stock, by definition, it's going to be equal percentages. In this case, just 0.125%. So if we think about incremental demand for that stock relative to the amount of outstanding stock, it is the same for all of the stocks in the index. And that means the increase in demand as a proportion of that outstanding amount is constant. So what we might expect is that there is a huge difference in demand if you market cap weight the index and there are inflows. So I don't think this argument holds up as an explanation for why large cap stocks have been favored by inflows to ETFs or other passive investment vehicles.

certainly, for this explanation, I think it draws a blank. Today's video is sponsored by Saxo. If you're an investor looking for a premium investment experience without premium prices, Saxo's revamped its fee structure to give you better value and more control. UK investors enjoy commissions of just £3 per UK trade and $1 per US trade. Plus, Saxo charges no platform fees, and currency conversion fees are just 0.25%. Other fees apply. Saxo Trader Go is perfect for everyone, offering intuitive tools and extensive charts, while Saxo Trader Pro is designed for the pros, featuring advanced features like algorithmic orders and multi-screen setups. Integrate third-party tools or use Saxo's APIs for an even more tailored experience. With access to over 70,000 instruments globally, including stocks, ETFs, bonds, mutual funds, and more, your investment opportunities are endless. Diversify with funds and ETFs, and make informed decisions with Saxo's in-depth market analysis and educational resources. Saxo is ideal for experienced and high-net-worth investors.

offering sophisticated tools and tiered benefits as a viewer of Pension Craft. Saxo is offering you an exclusive welcome bonus. Open an account and receive up to £200 back on online trading fees to help you get started. This offer is valid for a period of 3 months after your first trade. This offer cannot be used for FX and CFDs. To learn more, just go to the link in the description below. The next argument is about large-cap price elasticity. Now, don't be phased by what sounds like very fancy words. The concept is actually quite simple. If you have a percentage increase in the demand for something like a stock, what percentage price increase does that increase in demand cause? If elasticity is high, then you get a big price impact for a fixed amount of increase in demand. If the elasticity is low, you wouldn't see such a big price change. Now, in finance, we usually refer to this as liquidity. If you have a larger-cap stock, it tends to have a higher traded volume, and it also is cheaper to trade.

dollar amount size will have a smaller impact for a large cap stock than it would for a small cap. So if we plot market capitalization on the x-axis, and this is a log scale, versus the bid-offer spread, that's a difference between the average buying and selling price. Notice the inverse relationship. Large caps like Microsoft, Apple, Alphabet, those tend to have very small differences between the buying and selling price, and also a huge traded daily volume. If you buy a million dollars' worth of one of those stocks, it's very unlikely to move the price significantly, whereas for some of the smaller stocks in the S&P 500, the bid-offer spreads are much wider, and trading that same amount of stock will have a bigger impact on the price. Also, if you trade in and out of the stock, you'll pay a much bigger bid-offer spread. Now, there's a nice argument from Michael Green of Simplify Asset Management, which is focused on this idea of elasticity. His first point is not very controversial at all, which is how market makers make money when you trade.

you'll trade with the market maker. You'll be the market taker. And the idea is that these people have to trade whenever you want to trade, so they have to provide liquidity to the market. They can't time when they trade, but what they can do is they choose the price at which they buy and sell. They'll choose to buy at a low price and sell at a high price, and you'll take the other side of that market. Now the amount of profit they make depends on how many trades they do multiplied by that bid offer spread. More volume means more profit for them, and a wider bid-offer spread also means more profit for them. So this is why for large caps they have a lot more volume, so they're willing to take a smaller spread. And Michael Green puts the argument as follows. He says if I'm a market maker, I have to put capital up against trades to facilitate the trades, and the profitability of that capital is determined by the spread between the bid and ask and the quantity of shares that

are being traded now. Previously, we saw that a large-cap stock will tend to have a smaller bit of a spread, but how much smaller is really key here. He says if there's only five times as many shares being traded on Microsoft and it has a tighter bid-ask spread than Delta Airlines, then it's less profitable for me to put capital up against Microsoft in proportion to its market capitalization. And then he goes on to point out that if that's true, it actually becomes less liquid the stock Microsoft, or alternatively more inelastic, such that when you try to shove through trades in the size you have to for a market cap-weighted index like SPY, for example, it overwhelms and actually causes those names to rise more than they otherwise would be expected to. So really, this is a question about whether large-cap names have sufficient volume to pay for their tighter bit of a spread. But I think this argument falls down because what market maker wouldn't want to trade Microsoft. Okay, maybe they have to give up some bid-offer spread, but they determine that bid-offer spread.

they have to compete with other market makers, but they certainly wouldn't turn away business around flow for Microsoft. They're not the injured parties here, so I don't buy the argument that market makers are not going to widen bid-offer spreads if they don't have sufficient revenue. And sure, it's true that if you look at those numbers in the graph we saw, the bid-offer spread is tighter for larger volume names, but it's not the case that we're seeing lots of large-cap market makers going bust, far from it. So I don't really buy this argument either. I don't think this explains why companies like Nvidia have seen their share price surge. So this one also gets a no from me. The third argument is based on flows from active to passive funds. Now, this is something we're all aware of, and certainly if you look at Morningstar data for the US, you can see that in 2023 passive funds, whether those are ETFs or mutual funds, they have certainly now caught up with active funds.

assets under management are roughly equal for those two categories. Furthermore, it looks like they're set to overtake fairly rapidly. So the question is, is that trend going to drive large caps to be overpriced? Now I think this argument is actually quite convincing, but it's subtle, so bear with me. The key point here is that if you move from active funds to passive funds and have, say, the same exposure - let's say it's an S&P 500 fund - for the active fund, you were trying to beat the index. For the passive fund, you're just tracking it. But the question is, what kind of bias do the active managers have relative to the passive fund, which has no bias at all? It's just market cap weighted. Now, it turns out that if you are an active manager and you're benchmarked, say, to the S&P 500, you'll have to go overweight some names, but as a result, you'll have to go underweight other names. In other words, you'll take the S&P 500 weights so

7% for Microsoft, and you'll have to reduce those now. Which names will they go underweight? Well, usually it'll be the large caps, the mega caps, because they have lots of weights to start with. Remember, you can't go lower than zero when you go underweight, because that would be an overweight. So typically, it's been these large caps, the mega caps in particular, where active managers, the ones particularly which have a large active share where they deviate from the benchmark a lot, usually it's those mega caps which pay the price in terms of an underweight. So as a whole, what you tend to see is that active funds are underweight mega caps and large caps. Now, this argument, which is actually from two researchers at GMO, that's Ben Inker and John Peas, this rests on the observation that traditional active investors lean toward value companies. And as they say, if allocators and individuals substituted the portfolios run by these investors for passive indices, a negative demand shock should have taken place for value relative to their growthy peers.

to talk through their arguments in a flow diagram, which I think makes it simpler. If we imagine that money is being pulled out of active funds and deployed to passive funds, then because of the demand shock for value stocks and for small caps, what we'd expect to see is that small caps and value stock prices would fall. And as that continual movement of capital continues, we'd expect to see value to underperform and also small cap funds to underperform. Now, investors are going to see that underperformance, and this will create a kind of positive feedback loop where prices fall for those stars of investment, and money floods out of both active and passive value and small cap funds. Now, that's not to say that this whole cycle won't reverse at some point. There'll come a point at which valuations just get ridiculously large, but certainly this has been a trend that we've seen for some time now, and I think this explanation is probably the most credible one to explain how passive funds could have caused this disconnect in valuation, but also the

underperformance of value and small caps so this one gets a thumbs up from me. Now, there are other explanations which you can read about in the literature about why passive could have caused this movement away from value and small caps, and why stocks which are very much growth and large caps have dominated the US indices. And certainly, I think the third argument, which is based on the biases which active managers have and the demand shock, is the one which I think is the one that's most plausible. But tell me what you think in the comments. I'd be interested to hear your feedback about that. Plus, there are probably arguments which I've missed which may be even more plausible. Now, don't forget as a viewer of PensionCraft, you get a special offer from Saxo, a welcome bonus which is worth up to £200 back on your online trading fees. But terms and conditions apply. And if you want to learn more about that, you'll see a link to that in the description. And as always, thank you for listening.

Are Passive Index Funds Driving the Stock Market Bubble?

My name is Ramin Nakisa and I started PensionCraft in 2016 as I felt strongly that I wanted to teach people how to invest well for themselves so they could stop making costly mistakes and losing their money through having to pay unnecessarily high fees.

Before starting PensionCraft, I worked in investment banking as a strategist and I was a frequent contributor on CNBC and Bloomberg TV. I have written two books about finance and investment: one for professional investors and one that explains how to buy and sell volatility using exchange-traded products.

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Are Passive Index Funds Driving the Stock Market Bubble?

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