Passive, cap-weighted fixed income funds behave like momentum traders, buying more of a bond as its price rises. This is a flawed strategy for fixed income because many bonds are callable, meaning their upside is capped and rising prices increase call risk. Active management can exploit this inefficiency.
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Daniel Gladys argues that as passive investing grows, fewer participants focus on fundamentals. This widens the gap between a stock's price and its intrinsic value, creating a favorable environment for disciplined value investors who can identify these overlooked opportunities.
Market-cap-weighted indexes create a perverse momentum loop. As a stock's price rises, its weight in the index increases, forcing new passive capital to buy more of it at inflated prices. This mechanism is the structural opposite of a value-oriented 'buy low, sell high' discipline.
Unlike a market-cap-weighted stock index driven by competition, an aggregate bond index is dominated by the largest issuer: the U.S. government. The index mechanically buys whatever debt the government issues, regardless of duration risk or investor interests.
In bond investing, where upside is capped at a promised return, superior performance comes from what you exclude, not what you buy. The primary task is to eliminate the bonds that will default. Once those are removed, all the remaining performing bonds deliver a similar, contractually-fixed return.
Contrary to classic theory, markets may be growing less efficient. This is driven not only by passive indexing but also by a structural shift in active management towards short-term, quantitative strategies that prioritize immediate price movements over long-term fundamental value.
Terry Smith contends that passive investing is mislabeled. It's a momentum strategy that forces capital into the largest companies regardless of valuation. With over 50% of AUM in passive funds (up from <10% in 2000), this creates a powerful feedback loop that distorts markets more than the dot-com bubble ever did.
While active equity funds often fail to beat benchmarks, active management in fixed income tells a different story. Allspring CEO Kate Burke notes over 90% of their active bond strategies outperform over multiple time horizons, attributing this success to deep, proprietary credit research.
Jack Bogle's indexing assumed efficient markets where passive funds accept prices. Now, with passive strategies dominating capital flows, they collectively set prices. This ironically creates the market inefficiencies and price distortions that the original theory assumed didn't exist on such a large scale.
Market cap indexing acts like a basic trend-following system by buying more of what's rising. However, its Achilles' heel is the lack of a valuation anchor, causing investors to over-concentrate in expensive assets at market peaks. In high-valuation environments, almost any other weighting method, like equal-weight or value, is likely to outperform over the long term.
Tim Guinness claims that despite the rise of passive investing, it is not difficult for thoughtful active managers to outperform. He calls indices "stupid" because they are inherently momentum-driven and mechanically buy high. He argues a disciplined approach can overcome the fee hurdle that holds many back.
