Passive Investing Bubble: Not so Fast
Disclosure: I wrote this piece about two years ago when I was practicing my financial writing. I am happy to say upon revisiting that I still agree with the points.
The pace at which investors have been stampeding toward lower cost “index” options was featured in a recent NY Times piece, “Vanguard is Growing Faster Than Everyone Else Combined.”
Perfectly depicted by this chart from Morningstar:
Vanguard is considered the pioneer of passive investing – which, for simplification, is the acceptance of receiving the market’s return by buying and holding a basket of securities designed to replicate the market’s performance. This differs from active management – where a portfolio manager is paid a fee to try and pick only the best stocks in order to outperform the market. Although Vanguard does have a significant size of actively managed assets, the data supports that most of the inflows seen are towards their passive products. Pretty much everyone credits Vanguard’s “low fees” as the cause for this seismic shift in investor’s behavior. If you don’t pay an army of expensive analysts to do stock research, you can save a lot of money for your investors by lowering fees…
However, as I am fond of saying, a fee is only relevant in the absence of value. It is a valuable exercise to dig a little deeper to find the catalyst for this investment shift and what put fees in the crosshairs.
Barry Ritholtz points out how frequently the guests on his “Masters in Business” series cite luck as a fundamental reason for their success. Bogle is clearly a genius, but I suspect he would also admit to some luck playing a factor as an interesting aligning of the stars seems to have taken place for Vanguard’s wild success. I don’t think enough credit for this change to passive investing is given to the simple proliferation of the internet and the creation of the fair disclosure act. Vanguard’s product offering and unique capital structure set them up perfectly to capitalize on a tremendous change in information dissemination.
When Bogle first created the mutual fund he was ridiculed. Some called the product “un-American” and communistic in his acceptance of being average. For years Vanguard carried along in relative obscurity and then this:
Investopedia says, “The first modern-day mutual fund, Massachusetts Investors Trust, was created on March 21, 1924. It was the first mutual fund with an open-end capitalization, allowing for the continuous issue and redemption of shares by the investment company.” The mutual fund was then made famous by star stock pickers like Fidelity’s, Peter Lynch, who were able to make their investors rich by their stock picking prowess.
About 50 years later, Vanguard introduced their first index fund, and it took about 20 years from its introduction for the snowball to start to form. I don’t think the timing of the start of this snowball’s journey is any coincidence. Information asymmetry had long been a staple of the financial services industry. Investors, lacking information, were willing to pay professionals, who had information, a significant amount of money to have their money managed by someone “in the know”. As is common in all low barrier to entry fields, the wealth the portfolio managers were able to make attracted lots of competition.
Then the creation of the internet brought with it easy and instant access to information for the masses. Slowly this widespread availability of information evened the playing field with the investing “pros”.
However, and this is the key point, despite this leveling of the playing field – the fees being charged by money managers were not adjusted accordingly. So you had more, talented managers competing against one another, working off very similar information, and all aspiring to get rich in the process.
I don’t think there are many people that would disagree that managers have not lived up to the fees they are charging. In case you need hard proof, the SPIVA scorecard, which evaluates manager performance compared to their respective benchmark, was recently released and the numbers were humbling:
This data really blew my mind. The amount of times I have heard managers exclaim that their strategy will outperform after a full market cycle…. Well let’s just say I have heard that from every single manager who has pitched me. 15 years of performance is as full market cycle as we can ask for and yet more than 80% of all managers UNDERperformed!
This comes full circle.
A FEE IS ONLY RELEVANT IN THE ABSENCE OF VALUE. Well this data shows about as clear an absence of value as I think can exist. Why would you pay someone more to get less money back? Well obviously you wouldn’t and investors are catching on that this is the deal they have been signing up for with most actively managed funds. Seeing this data, I think it is even more obvious as to why the money moving to passive strategies has been so staggering.
A lot of pros are now talking about the tremendous opportunities ahead for active managers because of so much money fleeing. A quote from the Baron’s piece, “The Passive Investing Bubble Could Pop Soon“:
Meanwhile, Ned Davis of Ned Davis Research thinks we’re in the late stages of a bubble in passive investing. “Not only have index funds outperformed, but the crowd has noticed,” he writes. Over the past year, investors have yanked billions from actively managed funds and plowed more than $234 billion into U.S. stock ETFs.
“When one buys an S&P 500 index fund, one buys all the stocks in the index—whether cheap or expensive,” Davis writes, and today the price-to-sales ratio of the median stock has surpassed its level in 2000 and 2007. Trillions pumped by global central banks have lifted assets in tandem and made everything look more attractive relative to cash. But lately that correlation is fraying, a sign that “the trend toward passive investing is overextended.” Davis thinks the next five years will present great opportunity for active managers to outperform passive indexes.
Now Ned Davis is a far smarter and accomplished man than myself, but I find this to be a really difficult claim to get behind. I believe the reasons for underperformance still exist and they are:
- Career risk and organizational short-termism
- Managers working off the same/similar information
- More competition with less equities to choose from
If for some reason you are still looking to hire an active manager, I think the manager must to be able to prove the first point is not applicable to them. This situation is the outlier, not the norm, and for that reason I respectfully disagree with Mr. Davis’s comments. I do not think ON AVERAGE managers will be outperforming any time soon. Picking the small percent of managers that will outperform is a task that has yet to be accomplished by anyone I know repeatedly.
I do believe the rise in passive investing will eventually allow for active managers to showcase skills. This is because at some ratio of active to passive management, point three of my critiques becomes invalid as industry consolidation should reduce competition. I just can’t say with any confidence what that number has to get to for this to be the case. For this reason, I think it is very practical to continue to monitor the amount of assets in active versus passive strategies.
For US based products covered by Morningstar, the gap between actively and passively invested equities has narrowed. Looking at this data (below), I think it is hard to suggest a bubble in any sense. The passive assets are only just encroaching the levels of actively managed.
A seemingly more logical conclusion at this stage is that investors are in the middle of a tremendous wake up call that paying top dollar for underperformance is not a good investment.