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Passive Ponzi: A Dollar Into Index Funds Creates $17 of Market Value Magically Out of Thin Air

The Passive Ponzi: We have continually highlighted the work of Xavier Gabaix (Harvard University) and Ralph S. J. Koijen (University of Chicago, Booth School of Business) here on Passive Parabellum. Their ground-breaking 2021 paper, In Search of the Origins of Financial Fluctuations: The Inelastic Markets Hypothesis, illustrated the inflationary [as in artificially higher stock prices, not consumer prices] effect of cash inflows into index funds and ETFs (exchange-traded funds).

Passive Ponzi

Specifically, Gabaix and Koijen found that $1 invested in the stock market boosted the value of the market by $5. In this way, huge increases in wealth are created out of thin air. The reason is that markets cannot handle the tremendous inflows of cash into passive vehicles without large increases in stock prices. It is simple supply and demand.

This effect completely contradicts the Efficient Market Hypothesis (EMH), which postulates that all known information is incorporated into stock prices. EMH proponents believe that buying and selling by active managers will keep stock prices in line with their intrinsic value. However, how can this be the case when active managers as a group lose money year after year, causing them to be forced sellers in the names they hold in their portfolios? As a group, they cannot make informed transactions to guide stock prices if they are losing capital year after year.

Add to this the fact that passive vehicles never sell, creating a very skewed situation where active managers are forced sellers, passive vehicles buy constantly, and there are fewer and fewer overall sellers for passive funds to buy from, because passive is eating the entire stock market.

Does anyone truly believe that stock prices are rational given these dynamics?

Enter Mike Green, portfolio manager at Simplify Funds and probably the most influential voice in calling out the absurdities of the passive investing craze.

In Green’s research, he found that Gabaix and Koijen’s 5X multiple is actually understated and that the effect of $1 invested in the market is that market values increase an astonishing 17X!

Lest you think that Green is making this prediction after the fact, he has continually highlighted the mid-teens multiplier on podcast interviews. Remarkably, the 2023 increase in the U.S. stock market value tracked very closely with the 17X the amount of inflows into passive vehicles.

The impressive 2023 S&P 500 return of 26.29% certainly did not occur due to fundamentals, as the S&P 500 reported earnings growth of just 3.2%. Not exactly a blistering pace to get excited about, especially during a time of high consumer price inflation.

This magical melt-up courtesy of index funds and ETFs will continue until the inflows become outflows — a situation that may be triggered with rising unemployment. Then many will realize the magical returns of passive funds were based on ridiculous assumptions and academic malpractice. The Passive Ponzi will eventually be relegated to the dustbin of history.



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