Since its early days over 40 years ago, “passive management” (can it really be called management?) has attracted an exponential inflow of assets and a proliferation of products, now more than ever before. An era of easy profits?
Work less to gain more
“Passive” funds aim to replicate the performance of various equity market indices (after deducting fees). They may include index funds, ETFs (Exchange Traded Funds) and funds which pretend to be active but in practice stick closely to particular indices.
More and more of these products are appearing and total assets are soaring all over the world (currently over 14,000,000,000,000 euros), every day consigning active management further into history.
Thus, passive “investors” put their money or that of their clients into these passive funds, which are composed according to decisions made by the creators of the indices (the MSCI, S&P, STOXX or FTSE) to include and apply weightings to certain countries and companies, mainly based on stock market capitalisation.
In other words, without anyone monitoring, analysing or valuing the underlying companies (c. 2500 companies forming the famous MSCI All Country World Index for example), money is literally “invested” in the unknown (including value-destroying businesses, companies with non-transparent accounts, weapons manufacturers, etc).
The first point to note is that there are apparently huge numbers of individuals who think they can achieve satisfactory performances with little work or thought.
Would these same people be prepared to invest in a house without viewing it or without someone they trust assessing it on their behalf? If not, why would they do so when it comes to equities?
Cumulative flows to and net share issuance of US domestic equity mutual funds and index ETFs (billions of dollars)
Source: Investment Company Institute
The paradox of profiteers
Theory has it that financial markets are efficient if stock prices reflect all public and private information at any given time. To do so, assets must be liquid, identical information must be available to all, transaction costs must be low, and everyone involved must be rational at all times…
Passive “investors” believe in the Efficient Market Hypothesis, and hence that inefficiencies between fundamentals and valuations are too limited for active managers to be able to exploit them. Yet, at the same time, by “investing” in these index-based products, they implicitly assume that the weightings of stocks are correct since they are the results of all decisions made by active managers setting prices based on fundamentals... Yes, you read that right.
Howard Marks, the co-founder and co-chairman of Oaktree Capital, highlighted this point in one of his celebrated memos.
Charles Ponzi in the land of self-fulfilling prophesies
In their quest for profits, the strategy of passive “investors” is to sell on their basket of assets to other passive “investors” at a higher price later on, even though they have no idea of its current value (a detailed analysis and valuation of hundreds if not thousands of underlying companies would be necessary)…
Hence, the more the proportion of passively invested assets increases, the less the prices of stocks are based on a judgement of the underlying companies’ fundamentals, and the more the performance of the current passive investments depends on the inflows of new passive investments.
This is a worrying cocktail of pure speculation and self-fulfilling prophesies, which is reminiscent of a Ponzi scheme…
David Copperfield to the rescue of finance
Anyway, let’s consider the advantages of index products – which have an almost magical allure in the eyes of their advocates: low fees, liquidity, diversification, simplicity, and circumvention of disappointing active managers.
Low cost. Although very high fees obviously eat into performance, it is somewhat curious to focus frantically on costs rather than to concentrate on the product itself, especially in an area like investment. As if you could pay a Ryanair ticket price and then expect a first-class Etihad Airways service.
Moreover, they pay attention to price when it comes to fees, but not when it comes to the valuation of the assets comprising the product. Bizarre.
Diversification. Does the supposed benefit of greater diversification make any sense when, in some cases, it consists of “investing” in a greater number of low-quality companies, a greater number of overpriced companies, a greater number of unanalysed companies, or a greater number of correlated businesses?
Liquidity. On the one hand, subscriptions / redemptions of index fund shares are done at a price based on the value of the underlying stocks, only once a day. On the other hand, ETFs trade like stocks, but their price relies, among other things, on the goodwill of market makers and “Authorised participants” (the intermediaries accredited for the creation / redemption of shares) who are supposed to make arbitrages between an ETF price and the value of the underlying stocks. So how can anyone claim that these products are more liquid than the underlying stocks?
This contention is well illustrated by the “flash crash” on 24 August 2015: at one point, the S&P 500 Index hit a low at -5.3% from the previous day’s close. On the same day, the iShares Core S&P 500 ETF traded down by 26.0%! If you have a weak heart, beware.
However, it is precisely during panics that investors are desperate for liquidity.
Simplicity. Successfully investing in equities (excluding the effect of chance) requires an understanding of different fields, controlled emotions, experience and a lot of work, among other things. Despite this, many people think that equity markets are easily accessible.
Does the fact that capital markets finance is not a “hard science” advocate for not turning to a professional, as one would do to select appropriate medication or get a car fixed?
Circumvention of disappointing active managers. Does the fact that a notable proportion of active managers have underperformed indices necessarily mean that:
- there aren’t many managers who could outperform?
- as this has happened in the past, it’s bound to be the case in future?
- all investors are focused solely on performance and prepared to accept the full force of the markets’ volatility and downsides?
With passive funds, you can avoid suffering an active manager’s disappointing performance, but at the same time, you can never beat the indices and you will have to bear the entirety of its volatility and downsides.
Lemmings on a roller coaster
It is precisely that point which could surprise a lot of people. Markets having risen sharply for nearly 9 years now (and the S&P 500 which only had 4 days with a fall of more than 1% over the past year) encourage complacency and make it easy for some people to forget that markets can sometimes plummet (the S&P 500 has experienced 25 bear markets (declines of over 20%) since 1929, which is an average of one every three and a half years).
Given gain-loss asymmetry (and most Homo sapiens’ risk aversion), it is more important to limit the losses in difficult markets than try to capture the full extent of periods of euphoria – and it seems illusory to expect a product to continually achieve both.
What some people may have forgotten or concealed is the fact that nobody can predict market downturns and, just as passive “investors” have been carried along on the way up, so they will be dragged down in the descent, or even more (cf. “flash crash”).
Our objective here is not to predict an imminent market slump. Nevertheless, asset prices tend inexorably towards their value, and sooner or later every bubble finds the appropriate needle.
“Sympathy for the Devil” - The Rolling Stones
Although they generally raise interest in inverse proportion to the height of the markets, we need to mention systemic risks.
On the one hand, given the way recent regulatory developments have been going, soon we might see a ban on mentioning the word “fund” within 500 metres of potential clients; on the other hand, the rapid reproduction of passive products and the fact that already around a quarter of global assets are concentrated in the hands of passives does not seem to worry too many people.
Why should it? It is not as if the majority of them would react en masse in case of panic and all sell similar products at the same time…
At this very moment, what would be the exact impact on liquidity, especially as ETF creators also lend stocks to short sellers?
Besides, as regards synthetic ETFs, which do not even hold the underlying assets and rely on “swap agreements” that are expected to deliver an equivalent performance to the index, what would happen in the event of a counterparty’s default? Or a resurgence of volatility? Or a crisis in much narrower markets like emerging markets or bond markets?
And lastly, by encouraging short-term speculation and over-activity, ETFs are only aggravating the consequences of high-frequency trading and other market parasites. To give some idea of the scale here, the daily volume of shares traded on the SPDR S&P 500 ETF has reached USD 16 billion (with an average holding time of a mere 16 days) compared to “just” 4 billion for Apple stock, the world’s biggest stock market capitalisation. Not so passive after all...
Meanwhile, some intriguing pronouncements have been made by Jack Bogle, the renowned founder, former chairman & CEO of the giant passive Vanguard, and Bill McNabb, its current chairman & CEO:
Bill McNabb: “We share concerns that frequent trading, not just of ETFs but of any securities, will reduce returns for investors. But, reassuringly, Vanguard’s research, conducted with actual shareholder transaction data, shows that most ETFs are held in a prudent, buy-and-hold manner.”[1]
Jack Bogle: “As a result, the annualised turnover rates are different in magnitude: stock turnover, 120%; ETF turnover, 880%. The implications of this rapid trading — call it speculation — have yet to be fully examined.”[2]
Market share percentage of total net assets of globally regulated open-end funds
Source: EY
Big 5, Big 4, Big 3
Now let’s turn, not to the big 5 African game animals, or the big 4 English Premier League clubs, but to the 3 Mastodons forming the passive “investment” oligopoly (BlackRock, Vanguard and State Street) and its impact. Surprisingly, it is another subject which does not seem to raise much concern.
Together, these three companies hold around three-quarters of the world’s passive assets and represent the principal shareholder in around 90% of companies in the S&P 500 Index, and even in total in over 1,660 US listed companies totalling over 23 million employees[3]. It is hard to imagine that these three would not try to exploit this position...
Besides, according to an article in The Wall Street Journal, Michelle Edkins, Global Head of BlackRock's Investment Stewardship, is said to have declared: “meetings behind closed doors can go further than votes against management…”[4]
Moreover, a daily-increasing number of passive “investors” are assigning their capital to companies almost entirely according to their market capitalisation, with no consideration for the business fundamentals. This is enough to send a shiver down the spine of the principles of market economy, governance, long-term perspective, law of competition, research, innovation, investment, productivity, growth, employment, and SRI.
Whether we are talking about an individual or a listed company, it is hard to imagine a happy ending for our society if those are no longer judged in terms of their actions…
“Whenever you find yourself on the side of the majority, it is time to pause and reflect.” Mark Twain
Looking solely at the performance of passive funds, and over a limited period, extrapolating this trend, and then deducing that this constitutes the best solution is a deterministic view, as only one observation occurred.
Does crossing a 10-lane motorway blindfolded without getting killed prove that this is a better solution than using the footbridge located a little further away?
A different view, which is to believe that it is better to invest for the long term in high-quality companies at prices below their intrinsic value will always seem more reasonable to us at BLI.
And, as we have already seen, the more the proportion of passives increases in relation to the actives, the less investment decisions are founded on reflection, taken rationally and based on fundamentals.
This will continue to widen distortions between company fundamentals and valuations, generating more and more stock-picking opportunities...
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[1] https://www.ft.com/content/53054716-e6e9-11e6-893c-082c54a7f539
[2] https://www.ft.com/content/f406d50c-bbcf-11e6-8b45-b8b81dd5d080
[3] Hidden power of the Big Three? Passive index funds, re-concentration of corporate ownership, and new financial risk. Fichtner, Heemskerk and Garcia-Bernardo. April 2017
[4] https://www.wsj.com/articles/the-new-corporate-power-brokers-passive-investors-1477320101
