Is Elon Musk Right To Worry About Passive Investing?Submitted by Silverlight Asset Management, LLC on February 4th, 2024
According to Bloomberg, Elon Musk’s current net worth is $205 billion.
This week, however, a judge in Delaware put a significant dent in Musk’s net worth, ruling that a compensation package he received in 2018 was overly generous and unfair to shareholders.
While much is being debated in the financial press about the judge’s decision, there’s another key element to the story that’s being overlooked. It’s also one that concerns the broader public more than how many billions Musk will end up with after he appeals the verdict. I’m talking about the role passive funds played in instigating the drama. If Tesla didn’t go up 743 percent in 2020, we probably wouldn’t even be having this discussion.
When Standard & Poor’s announced Tesla would be added to the S&P 500 index in November 2020, it caused a ferocious rally, because active investors saw an easy opportunity to front run the looming passive bid.
During that month, I wrote an article for Forbes titled: Do S&P 500 Investors Really Want To Buy Tesla Now?
The piece highlighted how passive investors were poised to buy the stock after it had already gone up 600 percent year-to-date, and 50 percent that month, at an extremely high valuation, which happened to exceed the entire US energy sector at the time.
Of course, passive investing giants Vanguard and BlackRock bought anyway, because that’s what they do. Market-cap-weighted passive funds always chase whatever stocks go up the most. It’s their ‘investment process’. Sometimes just chasing price momentum can sting, though.
Since the date of the article, Tesla shares are down 6 percent, lagging the S&P 500’s positive return of 43 percent. Meanwhile, the S&P 500 Energy sector is up 150 percent.
Long-term Tesla shareholders are still sitting on enormous profits, no doubt. But the passive investors who chased the speculative frenzy in late-2020 haven’t fared nearly as well.
No one benefited more from Tesla’s huge rally in 2020 than Musk. Ironically, even though passive index funds helped make Musk the richest person in the world, he doesn’t appear to be a fan of them.
On Tesla’s conference call last week, he compared index fund proxy advisor Institutional Shareholder Services (ISS) to the Islamic militant group ISIS. Musk seems to be worried about index-funds and their corporate governance advisors becoming too powerful, which may threaten the degree of control he has over key corporate governance matters at Tesla—his only publicly traded company.
Many were quick to dismiss Musk’s comment, because it came in tandem with him asking Tesla’s board for a raise. Basically, he wants a new compensation plan that will increase his Tesla stake to 25 percent. He argues this level of ownership will give him sufficient voting rights to lead the company in the right direction long-term.
Before casually dismissing Musk’s comment as purely self-serving, it would be wise to consider a warning issued by the godfather of the passive investing movement—Vanguard founder, John Bogle.
In 2018, a year before his passing, Bogle said, “If historical trends continue, a handful of giant institutional investors will one day hold voting control of virtually every large US corporation. Public policy cannot ignore this growing dominance, and must consider its impact on the financial markets, corporate governance, and regulation. These will be major issues in the coming era.”
Perhaps Musk is right to worry.
Currently, the passive share of US equity ETFs and mutual funds is at 60% and rising. If this trend continues unabated, it will dramatically impact voting rights in the future. Relatively anonymous corporate governance advisors at firms like ISS and Glass Lewis could become among the most powerful people in corporate America, because they advise on shareholder votes at the world’s biggest companies, which are increasingly owned by passive funds.
Although, as Bogle suggested, corporate governance is but one major issue to consider with market-cap-weighted passive funds.
As our financial system becomes increasingly passive in its composition, it is systematically steering capital in a manner that disrupts the valuation profile of the world’s biggest companies, which makes them less safe to invest in over the long-term.
Market-cap-weighted passive funds invest mostly based on the size of each company. For instance, when investors park their money in passive vehicles like target date funds or the SPDR S&P 500 ETF (SPY), they automatically hand over the most money (about seven cents of every dollar) to Apple and Microsoft, because those are the largest market capitalization companies in the US.
When passive flows are positive, the biggest companies benefit tremendously. But when the largest stocks become extremely overpriced compared to their fundamental earning power, it pulls forward future returns, which creates potential for nasty air pockets whenever equity flows turn the other direction.
A glaring example of how this works is the Magnificent 7 stocks—the cohort of mega cap stocks that includes companies like Apple, Microsoft, Tesla and NVIDIA. That group of companies was by far the biggest stock market story of 2023, rising 107 percent. But when financial conditions tightened in 2022, that same group lost 45 percent, which was more than double the loss in the S&P 500.
Mounting evidence suggests the trend of passively investing solely based on market capitalization is probably distorting the stock market and economy in other unhealthy ways as well.
Obviously, the ever-present passive bid creates an unfair playing field that favors the biggest companies.
Here’s an easy way to see this: If AI is indeed the next great frontier of technological advancement, why are existing tech giants like Microsoft, Google, and NVIDIA expected to be the prime beneficiaries?
Creative destruction is what drives economic progress in the long run, because it allows new companies with new ideas to nimbly create breakthroughs. It also keeps existing companies on their toes—constantly innovating—based on fear of being displaced. These are good things.
Yet, in today’s economy, a narrow set of tech giants is benefitting enormously from a status quo that’s being subsidized by passive investors. The biggest companies in Silicon Valley have enormous balance sheets and enjoy a permanent cost of capital advantage over smaller companies (as billions of incremental dollars continually pour into their coffers every month courtesy of passive flows). This gives them scale advantages that make it easy to outmuscle upstart competitors, or quickly invest $10 billion to capture the pole position on a hot new trend, like Microsoft did last year with OpenAI.
Another concern with widespread passive investing is how it contributes to wealth inequality.
This point is really simple. Passive funds are designed to disproportionately favor the richest companies, which are predominately run and owned by the richest people. This partly explains why former Microsoft CEO, Steve Ballmer, is now poised to collect over a billion dollars a year in dividend checks alone.
Wealth inequality is a global issue. Oxfam, a global confederation of NGOs fighting poverty and inequality, publishes an annual report titled, “Inequality Inc.” The report paints a disturbing picture of a widening wealth gap. While the fortunes of the five richest men have doubled to a staggering amount of $869 billion since 2020, nearly five billion people have been made poorer compared to pre-pandemic. Something is wrong there.
History shows economies function best when economic gains are broadly distributed, because it increases the velocity of capital. The marginal propensity for a poor person to spend an incremental dollar is much higher than a billionaire’s.
Also, when economic gains are too narrowly distributed, it creates an unhealthy amount of social tension.
Passive investing isn’t just an investment style, it’s also a story.
One version of the story is that passive investing democratizes investing by reducing fees to benefit the common man.
Another version of the story is that passive investing is akin to economic pollution, because it pollutes the free market signals that have traditionally guided capital towards its highest and best uses.
Which story do you believe?
Different views about the same things are what make a market. Personally, I view passive investing as something that started out as a fine idea in the 1970s, but probably isn’t anymore because now too many people are doing it.
Bogle was the first to acknowledge there’s a ceiling for how high passive share can go without deleterious consequences. We know the ceiling is below 100 percent, but where exactly is an open question.
In December 2023, Musk quipped, “The percentage of the market that is passive is simply, is too great at this point. At the end of the day, somebody actually has to make an active decision. The passive investors are riding on the decision of the active investors.”
We can see this idea in a simple metaphor.
Imagine a teacher tells a classroom of students that it’s ok to copy one another on exams going forward. When the next exam arrives, a few students stop studying and copy their neighbor. Since most of the class is still studying, most people pass the exam.
Then, the next exam comes around, and fewer students bother to study.
Then, the next exam comes around, and only 40 percent of the students bother to study.
If the trend continues unabated, it won’t be long until the overall class’s IQ is severely impaired, and everyone fails the exam.
We don’t want that to happen to our markets or economy.
* Originally published by Forbes. Reprinted with permission.
Disclosure: This material is not intended to be relied upon as a forecast, research or investment advice. The opinions expressed are as of the date indicated and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and non-proprietary sources deemed by Silverlight Asset Management LLC to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by Silverlight Asset Management LLC, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any of these views will come to pass. Reliance upon information in this post is at the sole discretion of the reader.