Is Passive Investing Toxic?

I can analyze the economy in specific detail for endless articles, but the health of the economy has had declining relation to the stock market returns lately. I calculated the correlation between quarterly GDP and the S&P 500 from 2008 to 2016. The correlation coefficient is 0.973 which signals there’s very high correlation between the two variables. However, you look at the data from 2014 to 2016, which is the time when the economy has been weak while stocks rallied, the coefficient of correlation has dropped to 0.819. It’s not surprising because investors aren’t buying stocks because of the strength of the economy. They’re buying index funds because that’s the hot trend brought about by low interest rates and historical active management underperformance. I think the most likely way for this trend to reverse is poor stock performance. When an investor is buying something he/she has no knowledge of he/she has a very low risk tolerance. A 10% correction could start a snowball effect as the money pushed into passive management gets taken out.

I would argue passive investing isn’t investing at all. It’s mindlessness. The reason why I have gone from liking the passive investing strategy to hating it is because of its increased popularity. As like when most things become popular, its original intent has been distorted. Investing in passive ETFs such as the S&P 500 index fund made sense because mutual funds had been shown to miss their benchmark. 67% of active management funds have missed their benchmark and 86% have missed their benchmark when you include the liquidated funds. The S&P 500 usually rewards investors over time if they buy and hold assuming they don’t buy the market near the top. The problem with this basic analysis is it became popular which has made it no longer relevant. It’s common sense that if everyone buys any asset, not only is the alpha long gone, but the returns become negative.

Index buying distorts the market as it makes capital markets inefficient which may be leading to productivity weakness. Correlation doesn’t lead to causation, but when companies aren’t being rewarded for their performance, capitalism doesn’t work properly. To be clear, index buyers are purchasing the stocks within an index based on their market cap (which affects the weighting). Small firms haven’t had the margin growth of larger firms in the past few years. This trend toward ETF buying may be suppressing the small companies and helping the large ones. This is the same effect regulations have. Hurting small companies hurts productivity growth because the best innovation comes from startups. This new system of index buying can prop up zombie companies with declining revenue growth (think IBM & Caterpillar).

This toxicity of rewarding bad performance is already happening because low interest rates are encouraging speculation in companies like Netflix which don’t have positive free cashflow. Index funds are accentuating the madness. A company can gain support from Wall Street by gaining market share while ignoring profit growth. Then once it gets into the S&P 500 or another similar index fund, it gets supported no matter what it does.

The face of the index fund trend is Vanguard which was highlighted in the NY Times this weekend for its enormous success. In the last three years, Vanguard has accumulated $823 billion. The other 4,000 mutual funds only accumulated $97 billion in assets. That’s an 89.46% market share. I have spoken to small investors who have become woken up to the large fees and underperformance active managers are charging. It is logical to pay attention to fees and performance, but it’s illogical to ignore what you’re buying. Just because one strategy isn’t working for you, doesn’t mean you repeat the mistake, by not following what you’re buying. Now is the time when paying attention to what you’re buying is especially important. Investors are going to wish they weren’t tied to the S&P 500 when it falls.

The best strategy when buying active funds historically has been to buy funds with low fees. Large cap funds from the lowest quartile of fees have outperformed the S&P 500 by 0.18% from 1992 to 2015. This is a classic case of throwing the baby out with the bath water. Investors are seeing their own fund underperforming (the average fund underperformed by 0.71%) and are deciding passive investing is a better strategy. The next trend which will occur after everyone piles into index funds is they will abstain from stocks altogether. Some millennials are doing so as they witnessed the latest crash in 2008. The third crash will surely make investors think twice about putting any money in stocks. It’s interesting to hear the logic of TINA (there is no alternative) investors. They cannot understand why anyone would switch to cash as they ignore capital preservation. The best thing to do when these investors give up will be to invest in the low fee active funds. There will more low fee funds than ever because the high fee funds are seeing large withdrawals.

The current trend towards index funds makes it more difficult than ever to outperform the market because companies aren’t being rewarded for good results. It’s already difficult to pick which firm in an industry will be the best performer. Now, even if you do so, you won’t be rewarded as much as usual. The only way active managers will outperform the index over the next few years will be to hold some cash. When the passive fund strategy is flushed out of the system, the active managers who are picking stocks will once again be able to outperform the index.

The point about index fund investors making it more difficult to pick stocks was lost on CNBC as it featured a quote by Thomas Rampulla, head of U.S. Financial Intermediaries at Vanguard. He stated "It's getting harder and harder for managers to outperform. There's been a real professionalization of the asset management industry on the active side." He then cited the fact that about 20% of assets were professionally managed 50 years ago, while today 68% of assets are professionally managed. Firstly, he is talking his book by claiming it’s tough to beat the market; he would say that no matter what the performance numbers said. More importantly, he ignores the self-fulfilling nature of index investing. The more money which is put into index funds makes it tougher to outperform the index which then makes more investors pull their money out.

Conclusion

Index investing is not a sustainable trend just like investing in the Nasdaq was a bad idea in the 1990s. Steer clear of the stock market until it becomes cheaper. Then, buy a low cost active fund or pick stocks yourself. It will be easier in the future.

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Don Kaufman: Trade small and Live to trade another day at Theotrade.