Since the 2007 financial crisis, the passive investment strategy is on the rise. Each year a new record is established concerning the amount of capital invested using this strategy. Nowadays, the success of the passive funds industry is so important that it starts to be an existential threat to the entire, more classical, active-based Wall Street funds offer. To use a buzzword, the passive funds industry can be defined as a disruption of the classical Wall Street ecosystem: the vigor and speed of this process explains the distinctly stinging tone used by both sides in the ongoing so-called active versus passive debate.
Our contribution must be viewed as an attempt to provide a heterodox approach to this debate, by focusing on a neglected aspect: the analysis of investors’ rational reasons for embracing this allocation strategy.
Usually, an investor is assumed to act according to the rationality hypothesis, which means an aspiration to maximize the expected return given a certain amount of risk, then we can only understand the optimality of the passive choice by acknowledging some deep structural changes.
Our provocative statement is quite straightforward: because two major structural changes in terms of stock market functionality and the capitalist market economy have made the passive strategy optimal. On one hand, agents are specifically choosing this strategy because the stock market is drying up in its function as a main reservoir of investment opportunities; the stock market is shrinking in favor of other, out of this market, solutions. On the other hand, our capitalistic economy is less competitive, which implies that oligopolistic and even monopolistic markets are increasingly the rule with dominating firms either listed in a stock exchange or not. Altogether, these structural changes explain the success of the passive strategy. By focusing too much on analyzing the passive world and its consequences, we are missing the forest for the trees!
Thus, our goal is to bring some light to the forest and to discuss its complexity.
We will proceed as follows.
First, we will offer a short overview of the existing, and endlessly growing, literature about the active versus passive debate.
While the overwhelming negative consequences of excessive passive investment for stock market functioning are well discussed and presented, investor rationales underlying the passive choice are neglected or badly defined. Our first step will be to provide a critical analysis of this neglected element.
Second, we will introduce some challenging questions:
The literature tends to explain the post ’07 success of the passive strategy without referencing any structural changes. But, if it were the case that no structural changes occurred, then why this delay until after the ’07 crisis? At its inception in the mid-1970s the passive index tracking strategy was a success but its success was never so fulgurant during the ’80s or ‘90s than in the last decade. Why? Does this late success tell us something about the changing structure of the global economy?
Third, to best answer those open queries, we will explain the passive strategy’s triumph by referring to two structural factors.
The first factor is what we call the stock market’s drying-up process.
In our view, since the Internet bubble burst at the beginning of this century, the stock market has gradually but definitely lost its centrality as a source of new investment opportunities. Alternatively, the market is drying up because the pool of fresh available opportunities is shrinking and the few remaining opportunities are too stringently hunted based on, often, too harshly short-term considerations. Given this phenomenon, a lambda investor’s opting for a passive investment choice is coherent with it: Investors expect to receive more from big capitalization firms and so disparage small and medium capitalization ones because investors do not believe in small firms’ potential.
Here, investors, sometimes wrongly, believe those rare pearls are too expensive, in terms of analyst fees, to be detected.
The second factor is based on a simple finding: The market web that shapes our capitalistic economy is declining in terms of competition. Several key markets are now organized as either oligopolies or even monopolies. Basically, this absence of competition tends to favor big listed firms and their forecast for future solid earnings: Therefore, the lambda investor’s decision to go passive sounds like a very rational choice.
If the capitalistic features of our economy have fundamentally changed, then it might be normal for some of its traditional frameworks to be, at least partially, disrupted.
I. A short review of the active versus passive literature: Where we stand with this debate.
Recently, the active versus passive debate has become a hot topic, and a long list of studies can be cited.
The bulk of this literature questions the current and growing passive trend: If this trend continues at the same pace, what will be the future of the stock market in a few years’ time? This is the main question and concern.
The stock market scenario under this trend is gloomy and the main reasons can be easily grasped. Two reasons are worth special attention.
1. An overwhelming acceptance of the passive strategy will inevitably generate a huge misallocation of capital. Huge amounts of money going to big firms’ shares is a penalty to small firms’ shares. Here, the argument is quite straightforward: Small but dynamic firms, in which capital is likely to generate its best return, get penalized because their share prices will no longer reflect future potential cash flows.
Thus, the price signal generated by the stock market is distorted and investors’ savings are no longer allocated in an optimal way. To use Renaud de Planta’s words: “That wouldn’t be good for productivity and growth” -All notes at the end of the paper-.
2. If more and more money is invested in passive funds, less and less will be available to managers of active funds. In other words, the more investment in passive funds grows, the less freedom in terms of both capital availability and stock-picking implementation active fund managers have. Here, a scenario where only a few active players remain in the market, becomes plausible. But then, what about the price mechanism under this new extreme regime? What about the efficiency of the price structure so obtained? If most of the shares available are detained under passive rules: how would the price mechanism work if only a few active funds remain?
This is an extreme scenario; the odds of reaching this territory are small. But, still, where is the process likely to end? Will it stop with room enough for active players and, therefore, ensure the survival of a “fair” price mechanism or not? No one, at present can answer those questions: They are nevertheless real threats.
The conclusion is clear, if the widespread passive epidemic continues its progress on the same path, then the stock market price mechanism as we know it will stop working properly. Its ability to deliver an optimal stocks price structure will be compromised and the consequences for the economy will be very costly.
Nonetheless, in depicting this gloomy scenario, no one can explain why the passive strategy’s amazing success story started right after the ’07-’08 crisis. The investors’ rationales, which brings them to choose this strategy instead of an active one, are badly treated and explained.
Indeed, only two main arguments are used to explain this choice.
A. By creating index tracker funds, the passive asset management industry has found a bright way to offer a diversified portfolio at very low fees for the clients. The funds’ holdings mimic those of an index. The way in which a fund manager allocates money among the stocks is easily defined, and depends on the weighting of each company in the index. Now, most of the time, the weighting index’s structure is in function of the size of the company, that is, its market capitalization. There is no real stock-picking mechanism here. The fund manager mimics the existing index, with zero added value but also with zero cost in terms of research to determine the right stock picks. Simultaneously, the passive fund manager offers a very transparent investment vehicle: any investor can easily grasp what an index is and how it works! For instance, it is likely that the transparency has played an important role in plenty of investors’ mind after the Madoff case.
Therefore, the passive offer is cheap compared to a classical active one, it is easy to understand, i.e. highly transparent, and, a priori, liquid.
B. Most investors are already aware of an empirical fact: Most active fund managers, once returns have been calculated after net fees and the medium/long-term have been considered, do not perform better than the market, they are not constantly beating the market. In other words, no one has been shown to be constantly good at picking stocks. The market always has periods in which it (or, better, its proxy represented by a chosen fund’s underlying benchmark index), will beat the active fund’s performance.
Therefore, the stock market, over the medium and long term is quite efficient. If luck is taken out of the equation, then no magic formula exists. Human and machine- algorithm today, more and more AI tomorrow- are condemned to accept some losses in return vis-à-vis the market .
Intuitively, factor A. is crystal clear: Passive investment is attractive because it is cheap, easy to understand and, ceteris paribus, liquid. Nonetheless, this was always so. A simple query then is why the amazing flow towards this form of investment took place the last decade. The question remains basically unanswered. This argument is too short to fully explain what is going on.
Factor B. is trickier and far more complex. Despite being a powerful argument in favor of a passive attitude, its influence is overestimated for two reasons:
1) The major shortcoming of this argument is, as usual, that past performance values do not guarantee future performance values. A priori, in our view, a lambda investor who is now deciding whether to embrace a passive strategy or take an active fund option, is always more concerned about the future than the past: The decision process is based on what the investor can foresee and not on what he or she has seen.
Alternatively, past data and past trends are not at all sure to be repeated! If efficiency is taken seriously and investor’s rationality is acknowledged, then an investment choice will place more emphasis on an investor’s future forecast than on a simple set of past performance data.
2) Stock market efficiency is a difficult subject whose analysis strictly depends on the definition of information used in the market at a certain time. This argument needs to be discussed by considering all the complexity of today’s stock-picking mechanisms. Ultimately, the arrival of first algorithms and now AI is moving all those mechanisms toward a more systematic data-driven process.
Does this evolution ensure more efficiency? What kind of efficiency is likely to result from a generalization of these technologies?
As said in footnote 2 we will soon devote a paper to those questions.
In any case, our intimate belief is that factors A. and B. are insufficient to fully explain the current run toward passive funds.
Let’s take a closer look at the decision process of an investor who decides to go passive. This should help find an answer.
II. The choice of passivity: An analysis of the lambda investor’s case.
Does a list of the main factors exist that is likely to explain why a lambda investor is choosing a passive strategy? To answer this difficult question, we need to acknowledge that becoming passive implies that our saving is allocated following firms’ weighting in each market index, which usually, because a weighting structure is in function of market capitalization, favors big firms and penalizes small ones.
Now, a passive investor is never fully passive. He or she is active when deciding to buy an index tracker fund and when deciding to leave it: Choosing an index tracking fund implies he or she is acting.
Even though intuitively straightforward the small investor experience is quite paradoxical. In a passive world in which each participant is supposed to not take actions, the lambda investor decides based on a set of information that is, a priori, more substantial than the simple knowledge of the weighting of each stock in an index.
Simultaneously, the investor’s perception and vision of the investment’s expected future returns are, ultimately, encapsulated by those weightings.
Then the problem remains, given those weightings, how can we grasp and understand the investor’s underlying motive?
It might be simply by noticing that buying an index-tracker passive fund means embracing a certain investment philosophy. We are conveying a certain vision of the status of the economy and its future, and we are agreeing to follow a corporate friendly policy.
Here, given the way a stock index tracker is built and the fund’s manager status, the passive choice implies the following:
1) Putting more money in big corporations than in small ones.
2) Taking for granted that your fund manager will not interfere with the way firms are run .
Why have these two simple factors become more valuable now than they were back then in the mid-1970s when John Bogle created this type of fund?
The answer is simple, but few commentators have given it serious attention.
Two major changes occurred. On one side our capitalistic economy is less competitive because big firms (either listed or not listed in a stock exchange) are much more powerful and wide spread in several markets and, on the other side, the stock market has faded in its role as a reservoir of value and growth. The stock market is literally drying up!
Equivalently, on one side, we have a first set of justifications arising from a paramount stock exchange evolution, and, on the other side, another set of arguments related to a profound transformation of the entire market’s capitalistic system in which firms conduct business. Let’s start by analyzing the issues related to the evolution of stock exchanges.
III. To understand fully the passive choice, we need to embrace a larger view of the economy: This choice is more rational than it seems.
III. A) Wall Street and its decline: Wall Street fades as a reservoir of small firms’ growth and value, the drying up phenomenon.
As we saw, by going passive an investor is weighting big firms more than medium and small ones. An element is implicit in this sentence: We are referring to listed firms in a stock exchange. Nowadays, more than in the past, quoted firms represent only a fraction of the web of businesses characterizing an occidental economy.
Historically, the total number of publicly traded stocks has been decreasing . Therefore, the pool of firms available to invest in, is shrinking.
This result originates from three sources: α) Some small-to-medium firms prefer delisting from stock exchanges and using private equity financing and venture capital funds; ß) M&As remain historically high after the ’08 crisis; δ) fewer IPOs are taking place; and μ) finally, thanks to an exceptionality long and ultra-loose monetary policy, we got now plenty of zombie quoted firms: their presence is an additional noisy factor when someone is looking for valid investment opportunities in the stock markets .
If those elements are considered, the stunning increase of passive investors, can be seen from a new, refreshing perspective:
Investors are not convinced anymore by active strategies because they believe, fewer undervalued companies capable of growth are available in the stock market.
Equivalently, investors are now aware and convinced, perhaps wrongly so, that the firms likely to be dominant in the future are no longer in the pool of quoted small capitalization firms: Those who will be in power, the future champions are outside and they are financed via other channels.
At first glance a powerful rationale explains the passive choice: Why should I spend money, which means paying fees to an active fund manager, to search growth companies among a shrinking set of firms when I know that growth and value are mainly created outside the classical Wall Street frame?
The answer is frank: If I must invest in Wall Street, it is better to distribute my savings, paying a minimum of fees, predominantly among big firms and fractionally, among small and medium ones: this is exactly the main feature of an index-tracker.
Alternatively, the success of the passive strategy is a product of the Wall Street crisis. People are choosing this way of investing because Wall Street is drying up in terms of offering new exciting opportunities. Small capitalizations, therefore those with minimal weighting in an index, are being, at their best, a secondary repository of future stream of value .
But why? The answer is twofold.
First, as already mentioned most of the dynamic firms are now operating outside the stock market: A firm does not need to become a stock market insider to be properly financed and therefore prosper.
Second, small capitalized listed firms’ valuations are constantly under stringent data-driven analysis. The generalization of quantitative and AI-driven stock-picking methods implies a constant scrutiny of firm’s results: quarter financial values need to fulfill market’s short-term expectations.
Ultimately, the old mechanism where Wall Street was the center of savings’ allocation process is broken, and it is fading because, basically, too much is asked in respect of short-term results: Being in the market is just too stressful, operating and prospering outside it is just a lot easier.
With that perspective, it is better to remain outside the stock market and wait until the size of the business, e.g. firms’ turnover, efficient chain of value and large distribution web, becomes large enough to, eventually, envision a market public offering.
Here, being part of the market is no more a way to be financed but a nice to have long/medium term goal once the business is well-structured and already successful. Clearly, this is an extreme statement and some cases prove the contrary: still the trend is there. Here, for a firm, entering in the market at maturity, allows to keep, more easily, the Wall Street (short-term) mechanic disciplined.
Let’s now move on and investigate our second series of arguments.
III. B) Big companies are becoming clusters of innovation to master their future and to survey a possible disruption process.
A firm’s environment is characterized by a twofold threat. On one side, day by day, the need to keep pace with the ongoing numerical revolution.
On the other side, is the need to constantly assess the possibility of a frontal disruption, likely to destroy or, at least, seriously reshuffle the entire market.
If all firms are facing this reality, then big firms have an advantage when a defense strategy needs to be defined. They can create a cluster centered around them in which to develop and master innovation.
In this situation, they can use -at least- two available options:
First, a priori, they can dispose of a certain amount of capital that can be injected into startup initiatives. In addition, they can use their web of relationships with venture capital and private equity firms to increase the size of their projects.
Second, they can optimize their efforts using their own research and development divisions, whose budgets can be huge .
By so doing, the important firms will try to achieve two goals:
1) To remain a dominant player in terms of current technology in use in its sector. A big firm protects its market position by endlessly innovating and keeping its degree of efficiency very high. The chain of value is endlessly reviewed, changed, and optimized.
2) To try to anticipate a possible disruptive process, that could modify the nature of the market in which it is operating. The big firm tries to sterilize the disruptor-technology by absorbing it into the existing organization. Therefore, big firms are always ready to absorb one or several startups present in their cluster or to fight fiercely to absorb something out of them. For several senior managers, the firm’s real competition takes place more out of the market than inside the market: A ghostly paramount fear can become more real than a tangible threat.
All in all, we see a new passive lambda rationale here: In a time where the innovation process has reached a stunning pace, big firms are, perhaps, paradoxically, the best equipped to mitigate this breathtaking constraint because they can, figuratively, build (defense) frameworks around themselves. Once a framework is built, it is likely that it will act as a shield, which will guarantee better resilience in keeping the business afloat in the medium and long term.
A last remark here: Big firms partially behave as venture capital organizations. Now, the final victim of this big firms’ cluster philosophy is the stock market. Indeed, most of the startups in a big company’s framework will end up never quoted. And Why this happens?
Three possible ideas might support an answer here:
α) Enough capital is available outside the stock market to ensure proper development. No need then, to quickly go public and even at a late stage this is no more crucial!
ß) As already stressed in section III.A), by so doing, a startup will just avoid entering a system in which data (e.g. quarterly financial results), are likely to become far more important than plan and vision in conquering its own market.
The Wall Street apparatus is in trouble also because too much, if not everything, is based on short-term objectives tracking: why should young dynamic firms be interested in entering the Wall Street biotope when their goals are medium to long-term ones?
δ) Big firms become framework builders by surrounding themselves with dynamic pools of startups. This clustering attitude allows these important firms to remain in close contact with another huge startup generator: the academic world.
Here, it can be a lot simpler to keep a smooth, non-accounting driven, attitude in firms’ startups if you avoid an IPO: This can be a positive factor when a firm must attract new talent directly from the academic world.
This final remark closes our analysis of the structural changes in the stock exchanges: The Wall Street ecosystem is, in our view, under attack not only because the passive industry is becoming too important, but mainly because less room for trial and error is available to young small to medium firms: collecting capital in a stock exchange is costly, perhaps, too costly.
Let’s move on to the last rationale, that highlights more general aspects of the status of the capitalistic economy we currently live in.
III. C) Most big companies do not operate in a competitive market.
Historically, what are the main forces that have reshaped the entire capitalist system since the financial crisis of 2008?
Most of us would answer by saying the deepening of the globalization phenomenon or the fantastic acceleration in the numerical revolution. Few, would point out the lack of competition characterizing several markets.
Still, in plenty of sectors, few powerful firms are managing most of the supply side of the market. Consequently, in plenty of markets, insiders’ power is becoming progressively concentrated: big firms nowadays are operating mostly in non-competitive environments either oligopolistic or even very close to monopolistic market status- (e.g., Alphabet, to name the most classical example, with its Web search engine)-.
The US case is representative of a general worldwide tendency, as the US capitalistic economy is now under the spell of having numerous key sectors dominated by gigantic entities enjoying partially self-generated barriers to entry.
Do we have proof of this statement?
Sure, we have proof. Just take the example of the tech giants: Where are the real competitors of Google and Facebook or even Microsoft and lately Amazon?
Nowhere, at least in the occidental- (geography matters as we will see in a minute)- economic ecosystem. Similarly, we have the case of big banks: More than 30 big banks existed at the beginning of the ‘90s, so where do we stand almost 30 years later?
Four huge banks are left in the US!
But the same can be said for the automobile, energy, pharma and logistic markets: The list of sectors in which competition has been reduced to a minimum amount is massive. Add to this phenomenon the fact that even outside listed corporations, the famous startups, some of them with amazing turnover and valued billions -the famous unicorns- are playing, often in oligopolistic markets (see Airbnb and Uber as the main examples).
In short, we can simply agree with the analysis of Chicago Professor Luigi Zingales, who described in detail the historical background of this concentration-process. His work shows how it is precisely this phenomenon that defines the major threat for the American capitalistic model, based on a web of free and competitive markets .
Now, we are far less nostalgic than professor Zingales.
Why? Because this evolution is just how big occidental- (once again, geography matters) -firms are very rationally and efficiently responding to two extreme and violent forces:
First, a technological challenge that is a constant existential threat to any business via a possible disruption process.
Second, the never-ending globalization dynamic, which brings out new economic powerhouses, firms, and markets but constantly demands reassessing the chain of value and correlated price/offer positioning.
Alternatively, Zingales’ analysis, which we agree with in several aspects, pays almost no attention to two points:
The fact that an economy, as large and powerful as the United States, is never a closed ecosystem, and simultaneously, that firms nowadays, live under a constant threat of seeing their chains of value and ultimately final offer become obsolete in a very short period.
It remains without a doubt that the lack of competition is a source of inefficiency for the final consumers. Antitrust legislation has been created in all (occidental) capitalistic states to fight this inefficiency.
Why are those policies not triggers?
Most commentators will explain that competition is stunted due to the presence of lobbies at the level of the legislator and the fear of blackmail over losing jobs.
For us, it is a lot more complicated than that, once the globalization factor is taken properly into account:
Antitrust legislation is not triggered because, those big firms are our global champions!
Occidental governments accept the presence of those consumers’ inefficiencies because those firms are engaged in a worldwide competition with other groups outside the country, hence, political apparatus protects them in the country market, to guarantee their full strength externally and to compete in the worldwide market .
But why is strength outside a country’s borders so important?
Because, in plenty of cases, the place in which the key markets are, but also where the value chains are physically set and major competitors are, is Asia.
For instance, it is there, not in the west, where most of the world population lives, and it is there, not in the west, where the middle-class is growing-which is the main target for any mass production offer-. Finally, it is there, not in the west, where new major groups grow and planning to conquer traditional occidental owns markets.
Occidental governments simply acknowledge that competing in Asian markets implies huge effort and expenditures because “local” competitors are well protected- often by governmental measures- and, often they operate in mono/oligopolistic internal markets.
And here we see the spiral:
Occidental customers are forced to support inefficient prices- and, therefore, lose their own purchasing power-because their national corporations need to enter in the Asian/global market! Occidental consumers are under the spell of a geopolitical game that is well out of their reach but still cost them-and we are not talking about the cost as workers-.
Moreover, after the crisis, several listed big companies in occidental countries received a gift that was quite expensive for the taxpayers. Several of them are now considered, in one form or another, too big to fail.
If the situation is like this, and it is, we can see a powerful rationale for a lambda investor to go passive:
Big firms are, in principal, heavily protected in terms of barriers to entry- even though the possibility of a technological destruction is always open-. No one’s will trigger -seriously- antitrust policy against them. Big firms are global players ready to play in growth countries and endorsed by a too big to fail policy that ultimately guarantees solvency against almost all risk!
Why under these conditions, would I spend time, energy, and money to find small quoted firms that can ensure future cash flows with minimal risks (this is the basic principle of finance) when I have the opportunity to cheaply diversify my allocations among huge, heavily protected firms with almost no risks?
To be complete, under those conditions, an investor should prefer a blended allocation strategy: a mixed between a passive market one and a direct participation to the outside more dynamic world, e.g. by investing in a venture capital and or in a private equity funds. On that side, a strong asset management structure is likely to become the key edge in the private banking industry: the ability to efficiently pinpoint the right mixture at the right time, under the constraint of a « dynamic » client profile, it is likely to become the leading ingredient for a winner offer in this industry.
To conclude, the success of passive investment is a complex phenomenon that cannot be explained only by referring to low fees or the stock market efficiency:
We just illustrated another way to consider phenomenon and try to trace and discuss all possible consequences.
 Renaud de Planta, “The hidden dangers of passive investing”, FT.com, May 2017.
 I will discuss in more detail the efficiency of the market and its relationship with AI in the paper “AI and Stock Market efficiency: Some General Considerations.”
 We assume that a passive investor accepts a « […] hands-off approach to investing [provided by a passive fund]: One reason Vanguard is able to charge such low fees is that it doesn’t expend a lot of resources investigating individual companies or meeting with managers. […] Its index-fund managers don’t engage with companies about their businesses. » In Frank Partnoy, September 2017, “Are Index Funds Bad for the Economy?”, The Atlantic.
 Please see the raw numbers presented here https://finance.yahoo.com/news/jp-startup-public-companies-fewer-000000709.html and here https://www.economist.com/news/business/21721153-company-founders-are-reluctant-go-public-and-takeovers-are-soaring-why-decline
 Concerning M&A deals in the US, please see: https://imaa-institute.org/m-and-a-us-united-states/ , US and European IPO data are presented in the OECD Business and Finance Outlook 2015, p. 206.
And finally the notion and the evolution of zombie firms in US stock exchanges is presented here: http://lipperalpha.financial.thomsonreuters.com/2017/09/news-in-charts-the-rise-of-american-zombies/
 It is interesting to note that some major university endowment funds have recently decided to pull back from passive ETF exposure, e.g., https://www.reuters.com/article/us-usa-funds-endowment-etfs/largest-u-s-university-endowment-funds-pull-back-on-etf-exposure-idUSKCN1BO2L0 But what to do instead? Well directly invest, in mainly major quoted stocks: The underlying rationale is that returns are more likely to come from owning fewer big firms than from selecting a portfolio of small/medium capitalized firms.
 Details of the amazing amounts of R&D expenditures can be seen here: https://www.linkedin.com/feed/update/urn:li:activity:6316546299462193152. Interestingly, not only tech companies are investing huge amounts. The R&D effort covers all major sectors, proving that the concern about how to master this unprecedentedly volatile innovation phase is ubiquitous.
 Luigi Zingales, A Capitalism for the People, Recapturing the Lost Genius of American Prosperity, 2012, Basicbook. Other general accounts of this phenomenon can be found here: https://www.theatlantic.com/magazine/archive/2016/10/americas-monopoly-problem/497549/ and here: http://equitablegrowth.org/research-analysis/market-power-in-the-u-s-economy-today/ .
 In Switzerland, the classical example is the pharma market: It is a duopolistic situation, explicitly protected by the Swiss political system, which does not complain even though drugs prices are well above the European standards. This is accepted because research and development are still based in Switzerland but also because, everyone knows, R&D is the best way to help this industry fight in international markets. Same can be said about the Swiss big bank and the way they are protected.