In today’s Exponential Investor:
- What impact have passive funds had on the market?
- Why is this so powerful?
- Could there be trouble ahead?
A man named Burton Malkiel once claimed that a monkey throwing darts at lists of stocks could hit on a portfolio just as good as one that had been painstakingly constructed by a professional. It was in a famous book called A Random Walk Down Wall Street.
Another man, a few decades later, said Malkiel was wrong.
It won’t land on a group of stocks as good as a professional portfolio.
It will pick an even better one.
That was after his company, Research Affiliates, had actually run a study on exactly these lines.
The study took the results of 100 monkeys throwing darts at the stock pages in a newspaper. Amazingly, the average monkey outperformed the index by an average of 1.7% per year since 1964.
“Malkiel was wrong,” stated Rob Arnott, CEO of Research Affiliates, who conducted the study. “The monkeys have done a much better job than both the experts and the stock market.”
And all investors, retail and institutional, young and old, have been taking this lesson just a bit too far, in my opinion….
Passive investment strategies have grown powerfully over the last years.
It’s an idea that grew out of disappointment with the performance of active fund managers, who weren’t beating the market after extracting their fees. Monkeys could do better, after all.
Passive funds, where a computer program automatically allocates all cash invested into stocks or other assets, have grown in popularity and outperformed active managers in terms of performance too.
In a self-reinforcing cycle, passive outperformance attracts new investors, whose money is blindly and automatically invested into the same kinds of companies, which improves the performance of passive strategies everywhere.
But as always, this trend carries a dark and dangerous undertone.
Mike Green of Logica Capital is perhaps the authority on this topic, and his work can be found on Real Vision, the Grant Williams Podcast, or Hidden Forces podcasts.
The problem he outlines is that passive strategies are not price sensitive.
Once you give your money to a strategic ETF (just buys the S&P), it will do so no matter what the price.
With 43% (and counting) of market cap now taken up by passive vehicle ownership, this is starting to create real problems.
Passive vehicles hold no cash, and they will buy Tesla stock at $1,700 or $170,000 if you tell them to.
But the real problem comes mainly from the other direction.
There is a level at which every fund manager will gate their fund, like Woodford did here in the UK, rather than sell his assets off at bargain prices.
That blocks investors from taking the cash out and puts a floor under the prices of those assets.
But if you go on your brokerage app and click “sell” on your ETF which holds US tech stocks, it will do so, at any price.
At any price.
There is not a price at which it will not sell the securities.
Every price is the right price. If you give the passive fund cash, it will invest. If you ask for it back, it will sell.
Remember how oil went negative when no one said it could?
Well Mike Green says that there are scenarios, if passive takes over enough of the market, where panic could genuinely reduce the market to zero.
With insufficient active managers left to buy the stocks of panicking passive investors, the passive funds trying to meet redemptions would have to bid each other down to zero, before you can say What the Fed…
They would have to, because that’s how it works.
We saw this in March, where ETFs were plunging far below their net asset values – ie, the value of the assets within the funds.
The largest bond fund in the world went 6% its NAV, and some gold funds sunk well below theirs. And that’s bonds and gold – the safe havens and hedges for a crisis.
The thing is, as I described in my book review of The Great Crash 1929, when an idea takes hold that a vehicle for stock ownership is itself a reason for success, then there is a problem.
Back in the 1920s, it was investment trusts. People felt like it was the “democratisation of investment”. What a great thing, they all exclaimed, that ordinary folk could diversify with just a few dollars.
Today, there are 3,000 publicly listed stocks in the US, but 7,000 ETFs – which are almost all passive vehicles.
So the same feels true today. It seems common that people believe sticking their savings in a FTSE or an S&P 500 ETF will be a great investment.
Warren Buffett famously proclaimed that if he were just a normal guy, he wouldn’t try and pick the market himself, he’d just buy the S&P. Never bet against the US! And he’s been right.
Because of lower fees, and a narrow market (big tech domination), passive funds have outperformed. And they’re available from every broker to anyone with a few pounds or dollars.
The truth that lower fees and a bit of humility do make passive investing a good idea gets the ball rolling.
Then Amazon, Apple, Microsoft, Facebook and Google all perform incredibly, year after year after year. Because passive funds often allocate investments by size (ie, the larger the market cap, the bigger the investment), size begets size, and the biggest and fastest stocks growing gain a leverage through automated passive buying.
And make no mistake – there is truth behind the idea, and this trend could be hugely powerful and continue for a while.
Especially as boomers, which mostly own active, are slowly selling, while younger people who have high passive ownership (as a %), are doing the buying. That shift accentuates the outperformance of passive over active.
Technology stocks are quite often newer and have retained greater founder ownership (less of the company is publicly listed), high volumes of buying has an exaggerated impact. (ie, because the founders hold and don’t sell, there is less liquidity, fewer sellers and this acts as a booster for price movements.)
If a company’s market cap grows, passive funds (again, 43% of S&P market cap) are obligated to buy more to maintain the proportions within the fund, which means more inflows to the same companies.
Outperformance creates outperformance because growth and momentum combine with passive (an analysis-free vehicle) to create perpetual outperformance.
So make no mistake, while I want to urge extreme caution about the potential dangers of passive investing, there are powerful reasons why it has happened and continues to happen.
I just believe that these things cannot outperform forever.
Going back to our family favourite, Howard Marks, there is always a price at which an asset becomes so much more expensive than a counterpart that no one wants to buy it.
A 2000 Ford Focus becomes preferable to a 2020 Aston Martin. Even if it’s £1 vs £5,000,000.
And when it stops, the leverage inherent in the financial structure will work in reverse on the way down.
Once these big index leading stocks start to underperform, passive funds will be forced to sell them to maintain proportions, and so on. Like everyone trying to leave a cinema where the doors are locked and the building is on fire.
Underperformance must come eventually. It’s not an opinion, it’s the rules.
Look at the Nasdaq around 2001, compared to where we are today. Outperformance draws in products which feed from it, and their collapse drives the return to equality with the S&P and Dow Jones (red and blue lines).
Source: The Author, on Twitter
In fact, if you’d invested in the Nasdaq at the top of the tech bubble, you’d have only just caught up with the other two…
Source: The Author, on Twitter
And if passive continues to outperform and draw more investors, then that will sow the seeds for its own destruction. The larger the passive market grows, the less free the market becomes. Passive vehicles are not analytical and not price sensitive. In short, they are not investors.
Like in the 1920s, they are hoovering up more and more investment, and playing their part in driving prices up.
Why does this matter? Who cares how prices go up, as long as they go up, right?
Well… for now, perhaps.
But passive vehicles are now taking up such a large share of market capitalisation that we can expect distortions to result.
It’s a bit like saying “don’t fight the Fed”. Flows into passive vehicles are value agnostic and say two things, that prices can exceed reasonable valuations a lot longer than many of us would like, but also that investing anywhere near the top could be a catastrophic move.
It’s up to you how to balance your own risk, but understanding the way in which flows of money into passive investment strategies are driving the current rally and the bull market of the last ten years should help to understand this final chart, which shows the history of the Wilshire 5000-to-GDP ratio.
Stocks have never been so detached from the economy.
The rise of passive is certainly part of the reason why.
Don’t give up on active managers quite yet.
Editor, Southbank Investment Research
PS If you share my concerns about the distortion created by passive fund inflows, you might be looking for more content like this, and for ways to protect yourself from when it all blows up.
If so, check out my colleagues’ dedicated newsletter for seeking out and protecting yourself from the biggest dangers in financial markets.