Investing in the stock market through passive funds is now becoming popular in India. In this post, Gurbachan Singh contends that while this is, broadly speaking, a positive development, we need to go well beyond this trend that has evolved on its own in the market. He provides a conceptual framework, and a policy prescription that deals with the basic issue of irrationality, which is – as much of the literature accepts – pervasive in the stock market.
Following the experience of the developed countries, a shift is happening in India from investments in actively managed funds to passive funds1. Assets under management of related exchange-traded funds (ETFs) increased from Rs. 700.41 billion in to Rs. 1,639.23 billion during November 2017-November 2019. While this is usually viewed as a positive development, there is also a concern.
When additional money keeps pouring into passive funds, that money is used to buy relatively more shares of companies that may be high-priced already, and that have greater weight in the index being tracked. In the process, the prices of such shares tend to rise further. Accordingly, the passive funds can perform significantly better than actively managed funds. This further attracts flows into passive funds. And the story repeats itself. Such a shift to passive funds makes markets less, and not more, efficient. For this reason, some academics/practitioners have reservations about shift to passive investing (Arnott et al. 2018). Although this is an important issue and has received a good amount of attention, it is not the basic issue.
The basic issue is that more generally the financial markets are not unambiguously efficient and this matters for the real economy. So, the question is – what is at the root of all this, and what can policymakers do about it? But before we come to all this, we need to quickly review the Efficient Market Theory (EMT).
Market efficiency: Different meanings
There has been near consensus based on empirical evidence – at least in developed countries - that by and large, there is ‘no free lunch’ in the stock market, that is, arbitrageurs/traders cannot consistently make excess risk-adjusted returns over those given by some stock price index. It was presumed for a long time that ‘no free lunch’ implies that ‘prices are right’. However, it was gradually realised that though ‘prices are right’ does imply ‘no free lunch’, the relationship does not hold the other way. In other words, ‘no free lunch’ does not imply that ‘prices are right’, given that there are, in practice, limits to arbitrage (Barberis and Thaler 2003, and references therein). So, the stock market is not unambiguously efficient.
While ‘no free lunch’ matters a lot to the traders, ‘prices are right’ matters a lot for the economy. Hereafter, market efficiency will be taken to mean that ‘prices are right’. Hereafter, unless otherwise specified, it is assumed, for simplicity, that the stock market is micro-efficient. Next, if the stock market is efficient, it can either be micro-efficient, that is, ‘relative prices are right’; or macro-efficient, that is, ‘absolute prices are right’. Hereafter, unless otherwise specified, it is, for simplicity, assumed that the stock market is micro-efficient. So, the issue here is whether or not macro-efficiency holds. With this background, we can turn to the main issues now.
To begin with, and as a benchmark, let us consider a rational investor. I will come to irrational investors later. Unless otherwise specified, it is assumed throughout that all investment in stocks is through open-ended mutual funds only. The investors can invest in one more asset, which is a safe asset; it is assumed that such an asset exists (Tobin 1958). Unless otherwise specified, we assume that there is one stock price index (think of an index of large companies). I will abstract from the usual issues of taxation here.
We are already familiar with the classification of funds into active funds and passive funds. In this context, I will, for simplicity, assume that there are two types of investors – those who invest in passive funds, and others who invest in active funds. Now, in this post, I introduce another classification of investors. The investors can be, what I call, ‘sleeping investors’ or ‘awake investors’. The familiar classification is about whether or not fund managers are active in their choice of portfolio of stocks. The new classification is about whether or not investors vary their asset allocation over time depending on market conditions.
Table 1 below shows a two-fold classification of investors. There can be investors in passive funds or active funds (columns C1 and C2). Also, investors can be sleeping investors or awake investors (rows R1 and R2). In all, there are four categories of investors in Table 1. It has been assumed for simplicity that these are mutually exclusive and collectively exhaustive categories. The complete table will become clear as we proceed.
Table 1. Which category should an investor be in, ideally?
Investors in passive funds (C1)
Investors in active funds (C2)
Sleeping investors (R1)
if absolute prices are right or
sound financial advice is
not available at a reasonable fee
Awake investors (R2)
if absolute prices are not right and sound financial advice is available at a reasonable fee
It is intuitive if a person invests in passive funds and chooses to sleep over investments. It is also immediately understandable if a person invests in active funds and chooses to be awake as an investor. However, Table 1 allows for two other possibilities. First, an investor can invest in passive funds but choose to be awake as an investor. Second, one may have invested in actively managed funds and yet one could choose to sleep after making the investment. What can explain such investor behaviour?
In the context of the issues here, rationality may be taken to mean that an investor knows what s/he knows, and she knows what s/he does not know. For example, consider a finance professional. S/he can be rational in the sense that s/he is aware that she knows about financial markets (and not about, say, sociology). Next, consider an engineer who is rational in the sense that s/he is aware that she knows engineering; she is also aware that s/he does not know much about the complexities in the stock market beyond being aware of facts like active funds by and large do not outperform passive funds. Of the two investors under consideration here, one is well-informed about the stock market and the other is not. But both investors are rational.
Which category of investors in Table 1 is optimal for a rational investor? There is ample evidence that, on an average, actively managed funds, in fact, under-perform passive funds in developed countries. This did not seem to be true in a country like India for a while. However, in recent years, it is being increasingly observed that the result holds now even in a country like India (at least for the group of stocks of large companies, which is where the main interest is). So, clearly, in this context, it is not optimal for an ordinary but rational investor now to be in any of the two categories in the last column in Table 1. The next question is – should one choose to be a sleeping investor or an awake investor?
Before we consider the interesting and realistic case wherein ‘prices are not right’, let us go over the benchmark case wherein ‘prices are right’. Suppose that the basic idea of ‘random walk’2 by and large holds in the stock market. It ‘satisfices’ then to say that the probability distribution of returns remains the same after a possible change in stock prices. In this context, the optimal proportion of funds to be invested in the risky asset may be taken to be the same. So, the level of stock prices hardly matters in this context; basically, the idea is that ‘prices are right’ and they remain so, albeit at a different level, after a change in prices. In this context, it makes sense to be a sleeping investor.
Next, consider the main case wherein ‘prices are not right’. Should one choose to be an awake investor or sleeping investor? This depends. If (and only if) sound financial advice is available at a reasonable fee, it makes sense to be an awake investor. The reason is simple. If stock prices are high (low), it makes sense for long-term investors to decrease (increase) the weight of stocks in the overall portfolio.
Of course, the decision-making of a rational, long-term, awake investor needs to be done under sound financial advice. The valuation metrics include the price-earnings ratio (P/E), cyclically-adjusted price earnings (CAPE), market price to book value (P/B), dividend yield (D/P), market capitalisation to GDP (gross domestic product), and other such measures (Campbell and Shiller 2005).
At this stage, given the discussion so far, the entire Table 1 is self-explanatory. Given the analytical framework above, what are the implications for returns for an investor? Clearly, these should be equal to or greater than the returns on the stock index. But what is the empirical evidence on returns actually earned by investors? In practice, returns for investors tend to be significantly – if not substantially – less than the returns on the funds they invest in (Dalbar Associates, 2020). Why? This is because many investors are, in practice, not rational, and they act on their own. They tend to get excited when prices are high and rising, and they buy more at such a time. Also, when prices are low and falling, many tend to panic and sell (Malkiel 2015, figure on page 255). Such investors need not be confined to the group of retail investors; they can be big (domestic and foreign) investors too.
In a sense, all this is not surprising. This is because if investors were rational and sound financial advice was available at a reasonable fee, then the outcome would not have been serious mispricing in the first place, which is the main case under consideration.
We have considered decision-making of an investor in a simple setting. We have seen that we have a problem even in this simple case. The difficulties can get compounded if we allow for the big variety of indices that exist, the possibility that relative prices too are not right, the number of countries one can invest in, and so on. Finally, we considered the case that there is a given set of investors who are sleeping or awake; all others are not investors in the stock market. Presumably, they remain non-investors. But do they?
On some occasions like the present times, the departure from rational behaviour can go very far. In the last few months, the stock market in India (and elsewhere) has been recovering from the huge and fast crash that was witnessed in the wake of the Covid-19 situation. The recovery too has been quite ‘impressive’. It is interesting that in this recovery phase, many people have entered the stock market, or they have suddenly woken up to possible gains. 3.04 million new accounts have been opened at the National Securities Depositories Limited (NSDL) and Central Depository Services (India) Limited (CSDL) from March to June 2020. Retail participation in the market has increased substantially (many people are working from home and investing directly in the stock market). The cumulative rise in the Nifty 50 Index is 48.5% in a short span of time from 23 March to 28 July 2020. Ignoring the massive fall in prices from February until 23 March 2020, what these new investors see is only a big bull market! In fact, the degree, and the pace of the rise in stock prices, is partly due to these bullish investors or traders.
The point of all this here in the context of the analytical framework in Table 1 is that the departure from the investor behaviour depicted in the table can be considerable. Accordingly, the need for a basic change in policy towards the stock market can hardly be overemphasised.
Briefly, the finance literature has considered solutions that include financial literacy (Lusardi and Mitchell 2014), the Consumer Financial Protection Bureau (Warren 2007), fundamental indices (Arnott et al. 2008), accredited investors (Finger 2009), and so on. But these suggestions have not taken us far. Why? It is not clear whether the above policies are paternalist policies to help gullible investors, or solutions to a market failure. If it is the latter, then it is not clear what the nature of the market failure is. A clear answer to this question can pave the way for an appropriate long-term solution. So, that is what I consider next. For simplicity, I will abstract from the paternalist policy towards investors.
The mispricing in the stock market has adverse effects on the real economy. If prices are not right, there can be adverse effect on real investment and thereby on the aggregate demand in the economy. Though this does not happen in a significant way very frequently, the effects can be serious, persistent, and far-reaching when it does happen (Koo 2018). This is akin to pecuniary externalities for the real economy. The standard solution to an externality of this kind in the literature is, in principle, a Pigouvian tax (Jeanne and Korinek 2010). In fact, if taxation has to be the solution, then we need a high tax rate in some phases of the stock market, given the scale and duration of the problem here. However, it is very doubtful if a tax is pragmatic in this context. So, the issue of it being a high tax in some phases is not quite relevant. What can be the policy then?
Observe that the root cause of market inefficiency clearly lies in irrationality. So, the variant of a high Pigouvian tax can be a new policy that can discourage the activity that causes externality. Keeping the broader perspective, and the Indian conditions in mind, we can have a new policy that includes the following four salient features: (a) education, examinations, and licensing of financial advisors are improved considerably; (b) a ban is imposed on the participation of an ‘ordinary’ investor in the stock market that is based on her own knowledge that can be incomplete, outdated, or even irrelevant; (c) the participation instead needs to be through a qualified and independent financial advisor only; and (d) although financial advice is mandatory, the investor retains the freedom to choose (Singh 2017a and b, Basu 2010, Singh 2009). The purpose of all this is to reduce the role of irrationality in the market.
The use of financial advice in, what is otherwise, an inefficient market can reduce, if not obviate, the need for some standard policies to deal with mispricing and excess fluctuations in the stock market. These policies include the central bank’s interest rate policy to curb a stock market bubble (as it was used, for example, in 1929), policy to discourage complexity and innovation in financial products (Bookstaber 2007), policy to push information-insensitive products from banks for less well-informed people (Gorton and Pennacchi 1990), and government intervention in bubble-crash cycle (Geanakoplos 2010).
In this post, I have gone beyond the usual classification between active investing and passive investing. I have introduced the additional classification between 'awake' investors and 'sleeping' investors. It has been observed that in practice, many people are awake and restless as investors, effectively act on their own, and in the process cause mispricing of stocks. I have pointed the direction that policymaking and related research can take to make the stock market more informationally efficient (and the macroeconomy more stable). In this context, while the endogenous growth of passive investing in India is a more or less welcome development, it will not take us far – just as it has not taken the stock markets in developed countries very far in the last few decades, from the viewpoint of market efficiency.
- The definitions are as follows. Active funds “give portfolio managers discretion to select individual securities, generally with the investment objective of outperforming a previously identified benchmark. In contrast, passive strategies … use rules-based investing, often to track an index …”. The fees can be significantly lower for passive funds.
- The theory of random walks implies that a series of stock price changes has no memory – the past history of the series cannot be used to predict the future in any meaningful way.
- Arnott, Robert D, Jason C Hsu and John M West (2008), The fundamental index - a better way to invest, John Wiley & Sons, New Jersey.
- Arnott, R, V Kalesnik and L Wu (2018), ‘Buy high and sell low with index funds!’, Research Affiliates, June.
- Barberis, N and R Thaler (2003), ‘A survey of behavioual finance’, in GM Constantinides, M Harris and R Stulz (eds.), Handbook of the Economics of Finance, Chapter 18:1053-1123.
- Basu, K (2010), ‘Prescription financial products’, Project Syndicate.
- Bookstaber, R (2007), A Demon of our own Design - Markets, Hedge Funds, and the Perils of Financial Innovation, John Wiley & Sons, New Jersey.
- Campbell, JY and RJ Shiller (2005), ‘Valuation ratios and the long-run stock market outlook: An update’, in R Thaler (ed.), Advances in Behavioral Finance, Volume II.
- Dalbar Associates (2020), ‘Dalbar 2020 Quantitative analysis of investor behavior (QAIB)’.
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- Gorton, Gary and George Pennacchi (1990), “Financial intermediaries and liquidity creation”, The Journal of Finance, 45(1):49-71, March 1990.
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- Malkiel, BG (2015), A Random Walk down Wall Street: The Time-Tested Strategy for Successful Investing, W. W. Norton & Company, Inc. New York.
- Singh, Gurbachan (2009), “Lacunae in financial regulatory framework vis-à-vis financial repression”, Review of Market Integration, 1(2):137-170.
- Singh, G (2017a), ‘Restrictions as substitute for taxes’, Invited lecture (on Institutional Economics), Indian Statistical Institute, Delhi Centre.
- Singh, G (2017b), ‘Towards financial prescription’, Ideas for India, 24 July 2017.
- Tobin, James (1958), “Liquidity preference as behavior towards risk”, Review of Economic Studies, 25(2):65-86.
- Warren, Elizabeth (2007), “Unsafe at any rate”, Democracy, Summer(5):8-19.