Nvidia Nears All-Time High Amid Rising Passive Investments

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Good morning. Yesterday, Nvidia shares rose 2.5 percent, pushing the stock nearly back to its all-time high from a few weeks ago. This upward movement raises a question: how much of this resilience is fueled by passive investors who continue to pour money into U.S. stocks without considering the price? While the answer isn’t straightforward, it offers a fascinating glimpse into the complexities of modern financial markets.

Imagine the market as a web of interactions, where every move creates ripples, affecting myriad interconnected entities. One pivotal question is whether the rise of passive funds has made markets less efficient and even contributed to bubbles, such as the recent AI frenzy.

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Picture this hypothetical scenario to grasp the dynamics: envision that all investor equity allocations are managed by four active funds—A, B, C, and D. To facilitate trading and risk adjustments, these funds also hold some cash. One day, funds C and D switch to passive investing, holding all stocks at market weight. Consequently, half of the market becomes passively managed overnight, mirroring a decades-long trend in the U.S. market.

During the initial adjustment period, C and D need to recalibrate their holdings to align with market weights, leading to some back-and-forth trading. This rebalancing affects individual stock prices based on whether C and D were previously over or underweight on those stocks. The extent of these price shifts depends on how flexible the demand from funds A and B is for those particular stocks.

Despite these adjustments, the overall market valuation remains unchanged because investor demand for equities hasn’t shifted due to C and D’s move to passive investing. For every stock that passive funds need to buy (bumping up its price), there’s another they need to sell (pushing its price down). Over time, the market reaches a new equilibrium, and passive funds no longer need to buy or sell to maintain market weightings. Instead, any new price movements result from the differing valuations between active managers A and B.

As passive funds accumulate more assets, they do so across all stocks proportionally based on the stocks’ market size, creating a general price impact from increased demand but no significant shifts between individual stocks. With fewer active participants, trading becomes limited primarily to funds A and B, except when passive funds make forced trades due to inflows or outflows, leading to less market efficiency. This constraint can result in a more rigid market and higher volatility, although we haven’t likely reached an extreme scenario yet in the U.S.

Interestingly, even in this hypothetical extreme, mechanisms exist to help realign prices with fundamental values. For instance, an undervalued company might either receive a takeover offer or start buying back its shares to drive up the price. Additionally, significant changes in earnings could prompt active managers to adjust their holdings, triggering price movements.

Further complicating matters is the intelligence of the fund managers. Let’s say funds A, C, and D were run by savvy managers while B was operated by less skilled ones. When C and D switch to passive, A is left trading with B. If B continues to misprice assets, it creates opportunities for A to generate more profit—assuming B eventually realizes its errors and corrects them through trading with A.

From this scenario, it seems the rise of passive investing hasn’t significantly impeded market efficiency or fueled the AI bubble, though this conclusion comes with some uncertainty. The shift from active to passive strategies could lead to broader, unforeseen consequences.

A notable observation from Ben Inker and John Pease of GMO highlights an intriguing effect on investor behavior. Active fund investors often favor value stocks and smaller caps, using fundamental analysis to identify mispriced opportunities. As assets migrate from active to passive management, there may be less demand for value and small-cap stocks, while larger, more liquid stocks like Nvidia might see increased demand due to their presence in major indices and the associated lower fees of passive funds.

Moreover, passive investing raises questions about corporate governance and the phenomenon of “ownerless corporations,” as discussed by the late Paul Myners. However, these effects on overall market efficiency seem relatively minor compared to the primary impacts.

To sum up, while passive investing might subtly shift the market landscape, its role in the broader context of market efficiency and asset bubbles, including the recent AI surge, appears limited based on current evidence.