Writer: Aditya Gupta
Editor: Hwan Choi
The Free Rider Problem
For the past fifty years, financial markets have relied upon a hidden engine called “price discovery.” In economics, prices are a public good, meaning they are costly to develop (in terms of research, analysis, and discussion), but anyone can utilize them. This public good has historically been supported by active managers—the hedge funds and stock-pickers who pay the costs of figuring out what a particular company is really worth.
Passive investors function as free riders in this model. Since passive investors believe the current market price is the true value, they will purchase all the available stocks within a particular basket, receiving the benefits of the market, without having to support the research that generated those prices. So long as the number of passive investors remains a minority of the total participants in the markets, the system functions properly. However, as passive investors represent an increasing share of market participation, the incentive structure underlying information production weakens. The Grossman-Stiglitz Paradox suggests that if markets were perfectly informationally efficient, investors would have little incentive to gather costly information, implying that prices may fail to fully reflect underlying fundamentals. We are currently testing the limits of this paradox in real time.
The data in Figure 1 illustrates a historic crossroads that occurred in early 2024. For the first time in history, passive assets under management (AUM) in the U.S. mutual fund industry exceeded active AUM. This historical milestone represents a significant turning point in the way that the incentive structure of the markets operates. Although the golden age of active management included many average stock pickers, their cumulative efforts produced the friction needed to maintain prices consistent with a company’s intrinsic value. Now that the passengers have taken control of the wheel from the drivers, the engine of price discovery is starting to sputter.
(Figure 1, Source: Morningstar Direct, 2024)
The Oligopoly: The Illusion of Competition
The transition to passive investing has resulted in a radical transformation in the industrial organization of the American economy. The “Big Three” institutional asset managers—BlackRock, Vanguard, and State Street—are now the single largest shareholders in nearly 90 percent of the S&P 500 companies. This high degree of concentration results in a unique distortion in how these firms compete. In a typical market, competing firms are like rival sports teams. Each team aggressively reduces prices and increases capacity to win market share from other teams. However, this competitive dynamic depends upon the assumption that each team has different owners. That assumption is no longer valid today.
An excellent example of this concept is the airline industry. The Big Three asset managers collectively own 20–22% of United, Delta, and American Airlines.
Under such conditions, a price war becomes economically irrational. For instance, if United Airlines reduces ticket prices to take business away from Delta and/or American Airlines, it may slightly increase the value of United’s shares. However, reducing ticket prices would severely damage the profit margins of both Delta and American—shares that also sit within the portfolios of the Big Three asset managers. For a common owner, reducing ticket prices would be equivalent to moving money from one pocket into another, while paying the costs associated with a price war to accomplish that transfer.
As such, the management teams of airlines operate in a world where their largest shareholders have a preference for maintaining stable profits across sectors rather than engaging in aggressive competition. While this does not require back-room deals, collusions, etc., it creates an environment where the dominant strategy of competing firms is “soft competition”—maintaining higher prices and limiting capacity growth in order to avoid a fight among owners. Antitrust regulators are just beginning to understand this new reality. Recently, the U.S. Department of Justice raised concerns about the common ownership structures established by these large asset managers as potential antitrust violations.
The Death of Price Discovery: Signal Decay
Instead of making investment decisions based on the quality of a company’s fundamentals, investors make them based on predetermined rules that do not consider the quality of the company. For example, an index fund will automatically purchase the top stocks of an index regardless of whether those companies are fundamentally good investments. When capital flows into a stock due to index inclusion, price movements may reflect mechanical demand rather than firm-specific fundamentals. The index fund buying the stock creates noise in the market that masks the true value of the stock.
The inclusion of Tesla into the S&P 500 in December 2020 offers a clear example of this distortion.
(Source: Macrotrends)
Tesla’s stock price (as illustrated in the first graph above) rose sharply compared to the company’s actual earnings performance. Tesla’s Price-to-Earnings (P/E) ratio increased to over 1000 times the earnings per share (as illustrated in the third graph above).
While Tesla’s growth story has been fueling the company’s stock price appreciation, its inclusion in the S&P 500 index greatly amplified its demand. Trillions of dollars in passive funds were forced to buy the stock immediately to minimize tracking error. When large, price-insensitive buyers enter the market, demand increases, as the market ceases to weigh the firm and instead simply weighs the money being used to purchase the stock.
Liquidity Mismatch: The “Burry” Warning
Beyond price distortion, this shift creates a structural vulnerability in liquidity transformation. ETFs provide investors with the ability to get in and out of positions instantly, while providing liquidity throughout the day. The problem is that the underlying securities that back these ETFs are often illiquid. This means that if investors were to synchronize their redemption of securities, there would not be enough buyers to purchase them.
This structure creates a dangerous illusion. As investors like Michael Burry have warned, the mechanism that keeps ETF prices accurate relies entirely on a functioning underlying market. Active managers have historically acted as a shock-absorbing function for passive investors, by purchasing underpriced assets and holding them until the price returned to equilibrium with the rest of the market. However, as active capital continues to decline, this stabilizing force will continue to disappear.
While this does not mean that a collapse is inevitable, it does mean that the market is vulnerable to state-contingent fragility. When everyone wants to sell at the same time, the “exit door” of the ETF is typically much larger than the “exit door” of the underlying stocks. If the two cannot meet, a liquidity vacuum forms and a violent re-pricing of risk occurs.
The Tragedy of the Commons
Indexing still makes sense for the individual investor. It remains a low-cost, efficient way to invest, and generally provides better results than most active investment strategies. However, when it comes to the entire system, this mass migration of capital to passively managed accounts represents a classic tragedy of the commons. What is individually rational for each investor is collectively irrational. We have experienced 40 years of a bull market that has been sustained by the efficiency of active price discovery—a public good that we have consumed without contributing to its preservation. As we enter a new era characterized by passive flows, this efficiency will begin to break down. Centralized governance is becoming more common among a concentration of firms, and prices will increasingly reflect the flows of liquidity rather than the intrinsic values of the underlying securities.
This results in the major question facing economists in the coming decade: Will a market capable of sending accurate price discovery signals exist when the majority of its participants are structurally unresponsive to price?
Featured Image by Nicholas Cappello on Unsplash
