Passive investing: the trillion-dollar trend pioneered by Nobel Prize-winning financial economists

Pick the winning stock and beat the market

If your knowledge about finance comes primarily from TV and movies, then you might think of it as a form of high-stakes poker. Classic movies like “Wall Street” or “The Wolf of Wall Street” and series like “Billions” portray the world of finance as ruled by ambitious and ruthless people. In their stories, investment bankers take great risks to outsmart their rivals against all the odds. And they reap financial rewards that end up ruining their whole lives – or at the very least their relationships and livers. Dramatized depiction of investment bankers’ lifestyles aside, the movies and TV shows do a good job of illustrating one perennial theme: that financial investment is full of greedy, overpaid bankers gambling to “beat the market”.

Investing in stocks has been understood as a game of picking the better performing stock for a long time. The market crash of 1929 seemed to confirm that stocks are unpredictable. Financial economists of the first hour have echoed this sentiment. In the minds of academics at that time the stock market was almost comparable to gambling. There was little interest in the stock market as an object of study. Investing in stocks was seen as very risky. If you were looking for an investment for the longer term, you were advised to invest in bonds issued by governments.

Be smarter and buy the market

The idea of “beating the market” by picking few winning stocks as central to successful investment has become less relevant today. It has been eclipsed by another trend, which one may call “buying the market”. The core idea is simple. Rather than picking some stocks and hoping they go up, one simply buys small amounts of a large number of stocks that together reflect the market. For instance, one might buy an index fund that tracks the S&P 500 or some other diversified collection of stocks. The idea here is that holding a diversified portfolio of stocks best ensures long-term profits: “passive” investment pays off in the end.

Today, such passive investment products are vastly popular. Index funds track major stock indices, like the Nasdaq or S&P500 or other broad indices that represent a whole range of stocks. Exchange traded funds (ETFs) package market segments by grouping stocks like index funds, but they can be traded more flexibly. Passive investment is cheaper and less complex, making it a popular investment option for individuals as well as institutional investors (like pension funds). Big investment companies like Vanguard and Schwab have become household names in finance in large part due to their passive investment products.

Financial economists model the idea of “buying the market”

In our recent article, we analyse an important interaction between financial economics research and financial industry. We study how the idea of passive investment, as described above, was brought about and popularized by academic researchers in financial economics.

Academic research underpinning passive investment started in the early 1950s, rejected the way the financial industry operated at that time, and proposed alternative investment strategies. The prevailing investment strategy among investment managers was to pick up the “best” stocks that would fit the risk profile of an investor. Thus, most investment portfolios were tailor made and consisted of relatively few stocks. Nobel Prize winner Harry Markowitz challenged this by putting forward a decision rule for an “optimal portfolio” of risky stocks. His key insight was that there is a trade-off between risk and expected return on investment that can be managed. His “optimal portfolio” rule tells investors to hold a well-diversified portfolio of many stocks that allows them to benefit from the reduction in risk without losing expected return. So, instead of relying on hopes to pick up few winning stocks, investors are better off combining the stock in large portfolios.

Markowitz ideas caught the attention of many financial economists. Some of them, such as Nobel Prize winner William Sharpe, asked: what would happen if all investors were to follow Markowitz’s rule? Well, if they all follow the rule (and have the same information) then they will all invest in the same “optimal portfolio” of risky stocks. The key insight of Sharpe was that this portfolio must then be the “market portfolio”. It doesn’t mean, however, that everybody invests in an identical way. Each investor still differs in how many safer assets like bonds they want to buy. That would depend on how much risk they want to take. This idea is encapsulated in the key model of asset pricing, the Capital Asset Pricing Model (CAPM), built by several financial economists in the 1960s.

CAPM: A model shaping the world

From 1964 onwards, the bank Wells Fargo launched two major initiatives to get the academic world of financial economics involved in designing investment products. One was to raise awareness of how to measure investment performance (using the CAPM, of course). The other was to fund several conferences in order to boost the profile of the research being done. They finally created the first index fund in 1971. Since then, many decades passed before the idea of “passive investing” has caught on in the way it has today.

Many fascinating books have been written about how this slow process came about. In his 2021 book about index funds, Robin Wigglesworth of the Financial Times describes how the bank Wells Fargo had “assembled an all-star cast of academics” of several Nobel Prize winning financial economists. And financial historians Peter Bernstein and Perry Mehrling devote their books to describe how the model moved from academic theory into business practice, starting from the 1960s. Slowly, but surely, the CAPM-fuelled investment products began to take hold in finance.

Challenges for all scientists

Our historical analysis of how the CAPM has shaped the world led us to propose a new perspective to evaluate models, like the CAPM, that derive their importance not only from putting forward new theories/hypotheses about the world but also by their success in shaping it. We call it “contextualist model evaluation”. According to us, models do not only operate in a certain context. They also can create whole new contexts – such as the CAPM being instrumental in creating the industry of passive investing. Our approach feeds on detailed historical analysis of model performance, the ways in which the model gave impetus for change, and how the model performance and creation of new context interacts. The bottom line of our article is that carefully describing all these aspects is indispensable to be able to critically appraise the scientific models that have the potential to shape the world.

But our view also raises new questions.

First, how can we genuinely understand the workings of financial markets in all their complexity? That science has the capacity to change the world has been mainly studied by sociologists of science; they call it “performativity”. Remarkably, philosophers of science have paid little attention to performativity. They have been more preoccupied with the standards of accuracy that make science the successful epistemic enterprise it is. Our “model contextualism” improves on these isolated views of philosophers and sociologists of science. It reminds us that there are standards for how well science allows us to understand the world but also, and crucially, that there is agency in its practice.  Understanding these dynamics for finance and the financial industry is crucial if we are to understand how to steer financial markets to be conducive to achieve inclusive prosperity.  It seems to us that more academic disciplines should busy themselves with critically investigating the finance industry, financial research, and their interactions. And financial economists should be openly inviting them to do so. This strikes us as a new, and urgent, reason for pursuing interdisciplinary exchange and research.

Second, how to establish what responsible financial research is? The CAPM passive investment story shows that responsible research has many different dimensions. It shows that responsible research in finance entails more than being a diligent scientist and doing one’s research with honesty and integrity. Financial economists have also shaped the world with their findings spilling over into and impacting the world of finance; thus, the likely (or unlikely) consequences of the research might also factor.

Passive investment has helped to democratize investment and the benefits it reaps. Participation in the stock market is no longer exclusive to large institutional investors and rich people. Participating in the stock market is possible for anyone with a bank account and an internet connection. That is arguably a positive consequence thereof. At the same time, passive investing has formed considerable players in the market to be reckoned with. Large index funds and those offering ETFs have now considerable concentration of ownership. Passive investment of large scale has the potential to distort markets. All the while, the actions and decision-making processes of large-scale passive investors are shrouded in mystery: it is often unclear to whom are they accountable.

Thus, the story of the CAPM shaping finance is also a challenge to how one might understand the idea of “social impact” of research. Socially impactful research can have many shapes – and shape the world in many, often unexpected ways. But how exactly should this be done? We hope to see some of the answers to these questions in future interdisciplinary research.

Conrad Heilmann, Marta Szymanowska, and Melissa Vergara-Fernández collaborate in the project “Values in Finance” within the Erasmus Initiative “Dynamics of Inclusive Prosperity”.