In what is becoming a recurring theme, a long-time reader (let’s call him Bob) sent me a link to an article about passive investing the other day – and asked for my views.
The article itself was unremarkable, a thinly veiled shill for an active investing product. Hence, I won’t honour it with a link, as I did for the Sunday Times article last week.
The point is, once you’ve seen a few of these articles, you quickly realize they all follow the same recipe.
Start with some stats on passive investing. In particular, talk about massive inflows into passive products. Reference the “bull market in passives” and “valuation disparities”.
Sprinkle in a few out-of-context quotes by Warren Buffett and follow that up with stern warnings for passive investors. “The end is near!”.
Then, once the audience is primed, it’s time to go in for the kill start pitching your “hand-selected” active funds.
The ones “structured to thrive in a passively-dominated market environment”.
With investment strategies employing “highly convex positions”, “asymmetric payoff opportunities”, and “taking advantage of implied volatility”, whatever that means.
By the time you get to this point, if you know what’s good for you, you want to click on the “x” in your browser window and stop wasting your time (and possibly money).
Except that I didn’t.
The Sum Of All Fears
The reason I didn’t is that I could tell that Bob, while rightfully skeptical, was also concerned.
Concerned that there indeed may be a “bubble in passives”.
That the popularity of passive investing products may have “overinflated” the value of the index funds he was buying.
That, ultimately, his hard-earned money could be at risk as a result of some unseen, unexpected danger lurking around the corner.
But is that really the case?
Passive Investing – A Relentless Rise
Let’s start with the basics.
To be fair, the words “a bull market in passives” do have some truth in them. Their performance (bolding intentional) over the past 20 years has been nothing short of astounding.
According to Morningstar, as recently as 1998, active funds had more than six times assets under management than their passive brethren.
Two decades later, the two pools of capital are roughly equal in size.
So far, so factual.
And this is exactly why you should ignore factoids like:
“Over 100% of gross equity inflows are into passive vehicles”
Of course they are. It’s no secret that money has been flowing out of underperforming active funds and into index trackers.
“Most settled trades are between passive index participants”
What else did you expect? By default, index funds hold the underlying index. The composition of the underlying index changes constantly. Hence, index funds trade often in order to mirror the underlying index.
Back To “Performance”
It’s important to go back to the topic of “performance” of the passive products.
Any time you hear stats like the ones above, you need to note that this performance is all about assets under management.
In other words, it has ABSOLUTELY NOTHING to do with the actual price performance of the index products themselves.
Because, as we all know, the price performance of a well-managed index product mirrors the price performance of the underlying benchmark, less a minimal fee.
If you held the S&P 500 index tracker, you’ve done very well – just like the S&P 500 did.
At any given point in time, the equity index fund you are holding is giving you proportionate ownership in all the stocks comprising the underlying benchmark.
Thus, the only way your index fund could be “overvalued” is if the actual underlying index is overvalued. Which, incidentally, brings us to the next point I would like to address.
Pinning The Blame
Sometimes, critics of index investing go beyond basic misinterpretation and start making truly egregious claims.
In the article sent to me, the author had the nerve to make the following statements:
“Passive investing is why the US stock market trades so highly”
“Passive investing is why small-cap stocks have had a historic period of underperformance”
And my personal favourite:
“The reason active funds have underperformed is because of price-insensitive passive funds” (!!!)
First of all, passive products are not limited to the US stock market or a specific sector.
There are literally gazillions of passive products out there covering every single asset class, industry, product, commodity, fixed-income instrument, geography, style, size, and a myriad of other factors.
So the argument that passive products somehow “overlook” sectors like the small-cap (incidentally, I own small-cap stocks – via an index fund), is pure lies.
But it is really the last argument, which looks to blame index funds for active fund underperformance on passive investing, that takes the prize.
In reality, index funds are an active manager’s best friend.
As more and more money flows into passive indices, there are fewer and fewer active money managers analyzing equities and other assets.
As I have written about previously, making money in a world with no active managers would be easier than shooting fish in a barrel.
Instead, the problem of the active investing industry is that it is still too big for its own good.
Put simply, there are too many people chasing the same limited universe of price inefficiencies. This is why, in aggregate, they underperform the market.
Layer in fees and competition from other folks who can actually beat the market and you see why active management, as of today, is a losing proposition.
The Truth About Passive Investing
Having said all of the above, there is one argument in the active-passive debate that I do buy:
Passive investing can contribute to market volatility.
When the price of an asset goes up, its relative weight in the index also goes up – at the expense of other index constituents.
Given index funds look to replicate the weightings of the benchmark index, they would buy more of the appreciating asset and sell a little of all other assets.
In markets with thin liquidity and many passive players, this can create a “melt-down” effect, where a decline in price becomes a self-fulfilling prophecy.
It can also go the other way and result in a “melt-up”, which is partially what happened back in August. Softbank made a massive bet on tech stocks, sparking a broad-based price rally until it corrected in September.
Is market volatility a problem? Clearly, not least because it can spill over into the real economy by inducing panic and impacting spending and investment decisions.
It is also a problem for those folks who get excited after a market run-up and buy at the top. Those same people typically get depressed after a market decline and sell at the bottom.
In other words, rinse and repeat until you are broke.
But for long–term investors, which is something we should all aspire to be, it’s much less of a problem than the financial press would like to make it out.
After all, if you buy on a weekly / monthly basis over a period of thirty-odd years – and follow that by gradually selling over the next few decades, the volatility will average out. Nothing to see here, moving on.
Sadly, alongside many hard-working, honest folks, the money management industry also tends to attract quite a few less than salubrious characters.
Sometimes, they will put forth arguments that sound compelling but don’t hold up to analysis. In other situations, they will simply lie. And often, it’s a combination of the two.
If you know what’s good for you (and your portfolio), you will ignore them and move on.
Happy (index) investing!