By: Will Martin, CFA
Senior Managing Director & Investment Strategist at Three Bell Capital
Although index and exchange-traded funds (“ETF’s”) have been around for 25+ years, money has absolutely poured into these investment vehicles (and conversely out of actively-managed funds) in the nine years following the 2008 Financial Crisis.
Many investors and investment companies that provide or allocate to these passive ETF’s and index funds, do so with an almost religious fervor, believing wholeheartedly that it is “impossible to beat the market”, so one should just “own the market” and give up on active investment strategies and vehicles entirely.
“…ETF’s are not Olympic-caliber investments. They are participation ribbons.”
The rationale for this mentality is understandably alluring. Passive investment vehicles are typically cheaper to own, highly tax efficient, and post-Financial Crisis, have generally outperformed active investments on the upside net of fees. Not only that, but the proliferation of “roboadvisors” has made it very easy for investors to create and manage their own passive investment allocations without any professional advice or assistance, further lowering costs.
So, if all it takes to be an Olympic-caliber investor is to create a set it and forget it, auto-rebalanced ETF allocation, and just let it ride for all time, why wouldn’t everyone simply do so? Because ETF’s are not Olympic-caliber investments. They are participation ribbons.
In this edition of Cutting Through the Noise, we take a good, hard, honest look at some of the serious and almost universally underappreciated potential pitfalls associated with passive investment vehicles:
- Market cap weighting can lead to price anomalies and a lack of price discovery which could inflame an already overvalued market,
- Overcrowded and undisciplined investing on the upside can lead to increased volatility on downside when the market eventually corrects, and
- ETF’s in particular carry a degree of structural risk that have systemic market ramifications if the stock market drops precipitously.
Let’s dive in…
How Did We Get Here?
In order to appreciate the oft-hidden flaws inherent in passive investment vehicles, you must first understand the history behind how we got here, namely why did passive investment vehicles exponentially proliferate over the last decade?
Following the Financial Crisis, stock index funds and ETFs, with their low fees and unfettered upside exposure, responded immediately and positively when the Fed and US Government brandished double-barreled fiscal and monetary bazookas and more or less forced the stock market higher with a combination of ultra-low interest rates and financial stimulus.
“This dynamic has facilitated an unprecedented $1 trillion+ transfer of assets from active to passive investment vehicles.”
By contrast, during that same time frame, active managers were exercising prudence, still reeling from the recent, dramatic and rapid drop in portfolio values. As a result, they were maintaining higher levels of cash and allocating to higher-quality, fundamentally sound securities.
The net result was that indexes led almost all active fund managers coming off the 2009 market bottom, and actively managed funds, with their comparatively higher fees and more conservative investment strategies, have yet to close the gap. This dynamic has facilitated an unprecedented $1 trillion+ transfer of assets from active to passive investment vehicles.
How quickly we forget that active management had significantly outperformed through the down market, and that sort of critical analysis and resultant positioning is rapidly becoming more and more relevant in this relatively overvalued market. We will take a deeper look into the historical performance comparing active and passive investing styles next month.
“The active manager sells the portfolio’s holdings when money leaves their fund, which puts the most downward selling pressure on their largest and most active holdings.”
The chart below illustrates the asset flows with startling clarity, with passive vehicles (index funds and ETFs) taking in about $1.4 trillion, and active funds losing approximately $1.2 trillion over the past 10 years:
Let’s consider an example that illustrates the negative effects this transition can and has had on active managers’ ability to properly value underlying fund investments.
Assume a money manager has to pick between two nearly identical companies within the same industry. One is included in the S&P 500, while the other is not. Active managers will typically buy the cheaper company that is not in the index, because they are getting the same earnings stream with similar management quality, at a cheaper price. The company that is included in the index, however, ends up being priced substantially higher, not because its better, but because it is included in an index to which capital is being allocated.
These valuation premiums continue to expand as money leaves active management in favor of indexing. That’s the self-fulfilling nature of this trade that keeps putting pressure on active managers. The active manager sells the portfolio’s holdings when money leaves their fund, which puts the most downward selling pressure on their largest and most active holdings. Thereafter, the passive fund ploughs into a stock index that chooses investments based heavily on market capitalization.
As a result, the cheap stocks get cheaper and the rich stocks get richer. The active managers’ performance has a heavy hand of downward pressure, where fund outflows beget selling their favorite stocks, which begets losses in their stocks, which begets further fund outflows. Meanwhile, the Indexers are on the virtuous side of that trade, where fund inflows mean buying more of their favorite stocks, leading to stronger performance and the subsequent fund inflows, and so on. That is, until there’s a tipping point, and the trend reverses.
“Unlike stocks selected by active investment managers, ETF’s and index funds do not operate according to a meritocracy.”
Passive Issue #1: Market cap weighting can lead to pricing anomalies and a lack of price discovery which can inflame an already overvalued market
As investment capital has been taken directly from actively analyzed companies and given to those that happen to hold a weight in an index somewhere, there are far fewer investors kicking the tires of companies to ferret out a competitive advantage, and many more investors who’s only job is to mimic the market as a whole.
Unlike stocks selected by active investment managers, ETF’s and index funds do not operate according to a meritocracy. Active investment managers seek to fundamentally and technically analyze companies in an effort to determine if that company’s stock is more likely to rise or fall, and then make investment decisions accordingly. Makes sense, right?
The majority of ETF’s and index funds eschew analysis altogether and instead use a “market-cap weighted” method of determining what companies are included in the index or ETF, which is the exact opposite of the traditional actively-managed meritocracy that has historically driven managers’ investment decisions. A computer program is used to ensure that certain parameters (like tracking a particular index) of the fund are observed, and from there the passive investment vehicles just operate according to that protocol.
So the more indexes or ETFs that a company is included in, the more ETF investment inflows will drive the company’s market capitalization higher. As a result, passive investment vehicles invest many times more money in the largest stocks than they do in the smallest stocks. Even many of the “total market” ETFs are in fact a concentrated bet on the behemoths—out of every dollar invested, as much as 90 cents is a bet on the largest stocks, saving just a dime to spread across the thousands of small- and mid-sized stocks.
Because of passive investors’ abiding and often blind faith in the efficient market, they have ploughed money into cap-weighted indexes, which deploy money into companies based upon their market value vs. stock price, competitive advantages, economic factors, or potential for appreciation. Basically, bigger is better with no critical data analytics, investment discipline, or methodology, and that defies the very purpose of markets—allocating capital to useful ideas.
“…investors are taking way more risk than they realize, as market cap weighted passive investment vehicles are driving prices higher than they would otherwise be driven on fundamentals alone.”
Passive Issue #2: Overcrowded and undisciplined investing on the upside can lead to increased volatility on downside when the market eventually corrects
Out of the 500 companies that make up the S&P 500, the 50 largest contributors to risk were responsible for just under half of the S&P 500’s risk. That means 10% of the S&P’s companies are responsible for a whopping half of the index’s expected price fluctuations. Their extreme bias toward the largest of the large-cap stocks means that a full 20 cents of every dollar is invested in the 10 largest companies in the S&P 500.
Take a look at the chart below:
So, why should this matter? As long as the stock market keeps going up and to the right, it doesn’t. But investors are taking way more risk than they realize, as market cap weighted passive investment vehicles are driving prices higher than they would otherwise be driven on fundamentals alone.
The difficulty for passive-investing devotees is that when markets decide to become narrow-minded, undiversified, and irrational, so too do their investments. During the last two bubbles—dot com and real estate—the S&P 500 bubbled right up with markets, as both the tech and financial sectors grew to nearly a third of the index before crashing down again.
The role that the “market” or “active” participants play is important in finding a fair price for stocks. Indexes use these “fair” market based prices to find levels at which to transact for the passive money that chases index returns and crowds into the same trade.
“…it’s conceivable that ETFs could find themselves in a downward spiral.”
With the current lop-sided state of cap-weighted indexes and with these indexes receiving the lion’s share of investment, it is very difficult for an investor to simultaneously practice the principals of diversification and remain devoted to passive investing. Herding into passive investments displays a deep disregard for the very principles of diversification upon which index investing was built.
Without active managers executing diligence and fairly pricing investments, those who have piled into ETFs in the last couple of years may very well be the same fickle bunch who sold their equity holdings in the 08-09 melt down. These capital destroyers can be exceedingly dangerous, as they often rotate back into the market at a high, and are likely to sell into any potential market declines.
This self-fulfilling phenomenon works in both directions, and it’s conceivable that ETFs could find themselves in a downward spiral if the confidence in overvalued markets cracks. The high valuations and concentrations of market capital in the index holdings will work against indexes, and when the market does in fact correct, the outflow from passive investment vehicles could be much more dramatic and abrupt than anything we have seen before.
Passive Issue #3: ETF’s in particular carry a degree of structural risk that have systemic market ramifications if the stock market drops precipitously
Let us turn first to the father of index investing, Vanguard founder Jack Bogle. Jack, the man who has railed against active managers for decades, recently declared that there will always be a place for active management. He pointed out here that without the role that active management plays in price discovery, passive investing in indexes and ETFs may break down at some point, “chaos” and “catastrophe” would ensue, and “markets would fail”, if passive investing strategies grew too big.
Take a moment and let that sink in. The crusader who went from the Don Quixote of the investment world to become The Don of the Index, is now waving the caution flag as the index world continues to careen out of control with new offerings under the momentum of their own growth.
To be fair, Jack seems to think we are still on relatively safe ground—blindly stuffing our cash into index funds and ETFs—until passive investing comprises approximately 75% of the entire stock market’s value. However, other market experts are less sanguine, placing the threshold closer to 50%.
In any event, as shown in the chart below, the passive world has recently passed over 30% of all financial assets and is growing quickly. At this pace, the 50% mark is easily expected to be reached within 7 years.
However, the passive investing craze has been primarily focused on the U.S. equity market with considerably less emphasis on international equity and fixed-income markets. In fact, when we look at who owns U.S. equities, as in the chart below, we find that index investors make up a very large portion of the total market. In fact, passive investments grew to 40% of all domestic equity holdings as of the end of 2016.
“…passive investing in indexes and ETFs may break down, and ‘chaos’ and ‘catastrophe’ would ensue if passive investing strategies grow too big”
And the research arm of Sanford Bernstein predicts that by next year, passive strategies will be 50% of the entire stock market. Take a look at the chart below and you can clearly see this trajectory.
It doesn’t take a PhD in applied mathematics to see that we are rapidly approaching the 50-75% range that Bogle warned could be the “catastrophic” tipping point. Although, it’s not a certainty Bogle’s threshold will be hit within the next few years, it seems clear that the warning call has evolved from “um, boss, you really might want to pay attention to this risk” to “Houston, we have a problem.”
Conclusions & Key Takeaways
Investing in Indexes like the S&P 500 and ETFs like SPY has proven to be an excellent way for most investors to get exposure to financial markets through low cost and generally tax efficient vehicles. As such, these low-cost solutions should be an important part of most investors’ financial plan.
If an ETF is well-constructed with transparent and understandable low-cost strategies that helps fill a necessary niche in a portfolio, by all means, include it. But separating the wheat from the chaff in the thousands of ETFs has become at least as important as sorting through all of the individual stocks to determine which ones to buy and sell.
However, like all things financial, one must still take care to diversify, not just by asset class, geographic region, style and market cap, but also by the type of investment vehicles and investment strategies.
This month’s blog is a clarion call to diversify beyond just the simple market cap weighted ETFs (like, SPY and AGG). ETFs have had a great run, which adds to their current popularity and future risks. Just because it is easy and appealing to buy an index does not mean they should be considered the end-all, be-all, one-stop investment shop.
Investors must consider getting exposure through active managers within certain market segments, alternative or non-correlated assets and potentially a relatively new option: smart-beta/fundamental factor funds. When money leaves the stock market (and it eventually will), and index investments are in net liquidation (and they eventually will be), the “active” market participants are likely to find better value in non-index names with similar businesses.
Next month, we will look to provide a common sense approach to mitigating some of the risks we’ve discussed in this blog and blending index investing with other sources of return to produce a reasonably cost effective approach to maximizing risk-adjusted returns.