Why You Should Reconsider “Buying the Index”: The Fall of Public Markets

Why You Should Reconsider “Buying the Index”: The Fall of Public Markets

Passive index investing has long been considered a prudent strategy for investors seeking broad market exposure with minimal fees. Grounded in the Efficient Market Hypothesis (EMH), which suggests that asset prices reflect all available information, passive investing assumes that outperforming the market consistently is improbable. However, significant shifts in the U.S. capital markets necessitate a critical reevaluation of this approach.

The Decline of Publicly Traded Companies

One of the most significant changes in the investment landscape is the secular decline in the number of publicly traded companies in the United States. From a peak of approximately 8,000 in 1996, the number has fallen to around 4,000 as of 2022—a 50% reduction.¹ This decline is attributed to several factors:

• Rising Costs of Going and Staying Public: Regulatory compliance costs have escalated, especially after the Sarbanes-Oxley Act of 2002. Annual costs for a public company are estimated between $1 million and $2.5 million,² deterring smaller firms from listing on public exchanges.

• Robust Private Markets: The maturation of private equity and venture capital provides ample capital without public market burdens. As of 2022, U.S. private equity assets under management surpassed $4.5 trillion,³ offering companies alternative financing avenues.

Concentration Risk and Market Distortions

The reduction in publicly traded companies has led to increased concentration within major indices. The top 10 companies in the S&P 500 now represent over 30% of the index's total market capitalization.⁴ Tech giants like Apple, Microsoft, and Amazon significantly influence index performance.

Simultaneously, net equity inflows into U.S. equity markets have been substantial, particularly into passive investment vehicles. In 2021 alone, U.S. equity index mutual funds and ETFs attracted net inflows exceeding $400 billion.⁵ Over the past decade, passive funds have accumulated over $3.5 trillion in net new cash and reinvested dividends, while actively managed funds have seen net outflows.⁶

These massive inflows into passive funds can lead to indiscriminate buying, potentially causing mispricing. Valuations can become narrative-driven, detached from fundamentals. The S&P 500's price-to-earnings (P/E) ratio was approximately ~25-30x through 2024 to date, significantly above its historical average of 15x.⁷

Implications for Diversification

Considering that 87% of U.S. companies with revenue greater than $100M are private,⁸ relying solely on public indices excludes a substantial portion of the economy. Private firms are often catalysts for innovation and job creation. Excluding them from portfolios means missing out on potential growth opportunities not reflected in public markets.

Stale Regulations and Market Structure

Regulatory frameworks have not kept pace with market developments. The Securities Act of 1933 and the Securities Exchange Act of 1934 were designed for a different era and have not adapted to technological advancements and the rise of private funding sources. This regulatory stagnation may inadvertently stifle innovation and limit investor access to emerging opportunities.

The Shift in Capital Flows

While passive investing has surged, hedge funds and active managers have experienced diminished inflows and industry consolidation. According to Preqin, hedge fund assets under management grew by only 2% in 2022, compared to double-digit growth rates in previous years.⁹ This trend reflects skepticism about active management's ability to generate alpha but also highlights challenges posed by the dominance of passive capital flows.

Why Investors Should Reevaluate Their Strategies

• Backward-Thinking Bias: Passive strategies are inherently backward-looking, emphasizing historical performance and market capitalization. This may overexpose investors to sectors that have performed well in the past but may not drive future growth.

• Increased Risk Not Accounted For: Elevated concentration risk makes portfolios more vulnerable to shocks affecting a few dominant companies. Traditional diversification benefits may no longer hold.

• Valuation Concerns: Elevated P/E ratios suggest potential overvaluation. Investing at such levels increases the risk of subpar future returns if earnings growth does not meet optimistic projections.

Additional Considerations

• Liquidity Illusion: Index funds offer daily liquidity, but the underlying assets may not be as liquid during market stress, amplifying volatility.

• Corporate Governance: Passive investors typically engage less in corporate governance, potentially allowing management to operate without sufficient oversight.

Conclusion

The evolution of U.S. capital markets calls for a reassessment of passive index investing. The decline in publicly traded companies, increased concentration risk, potential mispricing from indiscriminate capital flows, and elevated valuations challenge the effectiveness of traditional passive strategies.

Sophisticated investors should consider diversifying beyond standard index funds. Allocating to private equity, venture capital, or selectively employing active management strategies can help navigate today's complex market environment. This approach may enhance risk-adjusted returns and better position portfolios for future market dynamics.

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1. CNN (2024). The stock market is shrinking and Jamie Dimon is worried. April 2024

2. Retrieved from World Bank Data 

3. PricewaterhouseCoopers. (2017). Considering an IPO? The Costs of Going and Being Public May Surprise You. Retrieved from PwC

4. Preqin. (2022). 2022 Preqin Global Private Equity & Venture Capital Report. Retrieved from Preqin Reports

5. Standard & Poor's. (2023). S&P 500 Fact Sheet. Retrieved from S&P Global

6. Investment Company Institute. (2022). 2022 Investment Company Fact Book. Retrieved from ICI

7. Morningstar. (2021). U.S. Fund Flows. Retrieved from Morningstar Research

8. Apollo. (2024). Apollo Academy.

9. U.S. Small Business Administration. (2020). 2020 Small Business Profile. Retrieved from SBA

10. Preqin. (2022). Preqin Quarterly Update: Hedge Funds Q4 2022. Retrieved from Preqin Reports

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