Passive Index Investing; a Bubble Bound to Burst?

[ExFlyBoy5]

https://seekingalpha.com/article/4191148-passive-index-investing-bubble-bound-burst

Author discusses the fallacy of index funds. Note...just an opinion of one person, but he makes some interesting points.

Summary

In the last decade, trillions of dollars have flown into assets irrespective of both fundamentals and price.

Investors are euphoric about passive indexing, and it is becoming an overcrowded trade with low prospective returns over the next 5-10 years.

Because of changes in index construction mechanics, historical index returns are misleading.

Informed investors seeking a margin of safety should hunt for stocks that have been largely ignored and excluded by passive index/ETF products, especially those with high insider ownership.

Over the past decade, trillions of dollars have flown out of actively managed equity funds and into passive investment vehicles, most popularly in the form of mutual funds and ETFs that track specific indexes....

 

[RobbieB]

Another reason I have an FA stock picker dude -

 

[samclem]

Another reason I have an FA stock picker dude -

These are the types of folks who write articles like this. "Quick, run to my arms and save yourself."


In theory, there could be a point when the huge number of passive investors could make stock-picking a net winner (after costs). There's been lots written on this, and the bottom line is that we are nowhere near that point. The indexes available to passive investors keep getting broader and broader, which reduces the likelihood of what the author is proposing. But the main factor is that there are still >plenty<of folks with >plenty< of money turning over rocks to find the best deal, and every passive investor owes them a sincere debt of gratitude.

I do worry that there's a bit of overconfidence in the transparency and truthfulness of some of the companies, regulators, and national governments now being covered by indexes. We can hope that everything is on the up-and-up, but I'm not confident. I'll let others explore the depths of the bleeding edge of the emerging markets.

 

[harley]

I read the entire article, and other than the issue with the S&P changing it's method back in 2005 I didn't see anything there that was interesting or useful. And I didn't see anything that says why an active manager would be a better choice going forward. And I definitely didn't see anything explaining how to find the passive index beating manager. There was a lot of talk about lousy valuations going forward, but I've been reading that for a couple of decades now. I'm sure it will happen some, and other times the market will outperform. And I'm pretty sure anybody that has been paying attention understand the difference between real returns and unadjusted for inflation returns.

Basically I don't think the article added anything to the discussion about active versus passive. And there was absolutely nothing about how active management fees weighing down returns moving forward will be any different from active management drag in the past. All in all, totally unconvincing.

 

[Red Badger]

I read the entire article, and other than the issue with the S&P changing it's method back in 2005 I didn't see anything there that was interesting or useful. And I didn't see anything that says why an active manager would be a better choice going forward. And I definitely didn't see anything explaining how to find the passive index beating manager. There was a lot of talk about lousy valuations going forward, but I've been reading that for a couple of decades now. I'm sure it will happen some, and other times the market will outperform. And I'm pretty sure anybody that has been paying attention understand the difference between real returns and unadjusted for inflation returns.

Basically I don't think the article added anything to the discussion about active versus passive. And there was absolutely nothing about how active management fees weighing down returns moving forward will be any different from active management drag in the past. All in all, totally unconvincing.

+1
Riding with harley.

 

[copyright1997reloaded]

I haven't read the article. I am both a passive and active investor. Approximately 50% of my net worth are in funds, mostly index funds, with about 30% of my net worth in individual stock holdings and most of the rest in fixed income (some mutual fund, some individual e.g. TIP, iBond, CD ladder).

As the % of investment money going into passive investments rises, there has to be a tipping point where the small % of active money has an over-sized effect on a security price. The passive funds have no choice but to sell or buy based on market cap changes in a security caused by trading from individuals/active managed funds (assuming no net fund inflows or outflows).

 

[Oz investor]

passive funds rise with the indexes and fall with the indexes and your only 'gains ' are dividends and the magic of compounding if you participate in the dividend reinvestment scheme ( unless you decide the market is near a top .. and then sell out/down and wait for a 20% or more correction/crash and re-buy )

active managers try to beat the market ( but that is rarely a 100% winning strategy ) so will most likely have some big years and some lean years ( are you brave enough to back that active manager in the lean years hoping for some great years soon )

YOUR investment timing is a major factor here , along with your investment time frame ( can you wait for the recovery after the next big crash .. that recovery might take 8 more years ).

if investing was easy almost everyone would be multi-millionaires .

the good part about investing ( on your own behalf ) is .. it is not and all or nothing game , you can have some passive index funds some active funds and even bonds and investment property ( all at the same time if you wish )

 

[marko]

I haven't read the article. I am both a passive and active investor. Approximately 50% of my net worth are in funds, mostly index funds, with about 30% of my net worth in individual stock holdings and most of the rest in fixed income (some mutual fund, some individual e.g. TIP, iBond, CD ladder).

As the % of investment money going into passive investments rises, there has to be a tipping point where the small % of active money has an over-sized effect on a security price. The passive funds have no choice but to sell or buy based on market cap changes in a security caused by trading from individuals/active managed funds (assuming no net fund inflows or outflows).

If you're saying that there's an equilibrium to all of this, I tend to agree.

For me, a good AA and "Over the long haul" are the answers.

 

[jimbee]

Sounds like click bait.

 

[pjigar]

I theory this is true but we haven't reached critical mass for index funds. I recall Boggle or Buffet saying 60% is the tipping point.

 

[LOL!]

...
Informed investors seeking a margin of safety should hunt for stocks that have been largely ignored and excluded by passive index/ETF products, especially those with high insider ownership.

Can anyone give some examples of such stocks? If one invested in total market index funds, then they would be very few such stocks and would surely get added to the broad market index funds eventually. Plus they would be such a low percentage of one's portfolio that they would make no difference in outcomes anyways.

The article contorted itself to show that something like a West Coast Beaver Cheese Commodity Futures Index ETF was going to have problems, so it was good to warn investors that esoteric, low volume index funds are to be avoided.

 

[target2019]

SA articles have peer review, and some commentary is usually good over there. I'm not selling my index funds, though.

 

[Totoro]

As long as there remain at least a handful of decently smart investors around that trade actively, passive will win out because of lower costs.

These folks provide the rest of us free valuation services, and for that I thank them.

As soon as asset management firms start outperforming passive indexing as a group in their public equity portfolio it's time to reassess. So far, no sign of that happening. I doubt that will happen until >99% of all funds are passive.

Even then, it will balance out I expect: if the average active fund outperforms by more than their costs, more funds will go to active management. Capitalism at work.

 

[samclem]

They most important thing is that the system already has positive feedback and tends toward equilibrium. As the market gets a larger amount of passively invested money, there will be greater rewards for stock pickers and we can expect their numbers and (maybe) their quality to increase, perhaps even enough to overcome their fees. So, over time, we should have enough of this activity to keep passive investing viable.

 

[MRG]

How many times have you read this kinda nonsense since 1975? Remember Bogel's folly?

Realize that active fund managers are the darlings of the industry. Most fund companies can't compete on price with the big 3. Look at the cost of say T. Rowe's index funds or any others. There's reasons why they will never be able to compete.

 

[bingybear]

I didn't read the article, but Bogle was reported as

John Bogle, the founder of the Vanguard Group and the person who ignited the trend toward index investing four decades ago, acknowledged recently that this circle could turn vicious eventually and cause downright tragic events in the stock market.

“If everybody indexed, the only word you could use is chaos, catastrophe,” Bogle told Yahoo Finance at the Berkshire Hathaway annual meeting last month. “The markets would fail,” he added.

If everyone did indexing, where would you get price discovery?

 

[LOL!]

They most important thing is that the system already has positive feedback and tends toward equilibrium. As the market gets a larger amount of passively invested money, there will be greater rewards for stock pickers and we can expect their numbers and (maybe) their quality to increase, perhaps even enough to overcome their fees. So, over time, we should have enough of this activity to keep passive investing viable.

This won't happen because the index funds will still get the average.

For those few stock pickers that outperform and get "greater rewards", there will be a counterbalancing group of stock pickers that underperform. So the active management problem doesn't go away: An investor still needs to pick a consistently good active strategy, manager, or fund. There is no reason to expect consistency in all this, so whoever/whatever was good one year is not necessarily going to be good the next year. They could be good, average, or bad. There is really no way to know.

The same goes for asset classes. For instance, this year international index funds are taking it on the chin. Emerging markets were up over 30% in 2017, but are down about 4% so far in 2017.

Bottom line: this is an awfully unpredictable business, except one can expect and predict that a total US market index fund will return the market average each year.

 

[happy2bretired]

Another reason I have an FA stock picker dude -

Me too...I’m just too timid and unsure in stock picking. I’m happy with how I’m set up right now with my FA.

 

[OldShooter]

https://seekingalpha.com/article/4191148-passive-index-investing-bubble-bound-burst

Author discusses the fallacy of index funds. Note...just an opinion of one person, but he makes some interesting points.

Seeking Alpha is a "crowdsourced" site. No particular author qualifications are required; anyone can send in an article. Whatever Seeking Alpha gets is what you get.

In the last decade, trillions of dollars have flown into assets irrespective of both fundamentals and price.

Investors are euphoric about passive indexing, and it is becoming an overcrowded trade with low prospective returns over the next 5-10 years. ...

This is a slight variation on the "weak hands" argument that comes around during every bull market. The thesis is that latecomers to the market are naive and overpaying for assets, and that when the market starts to decline, they will bail. This is probably true, but it has nothing to do with passive investing. In fact, IMO people with the wisdom to passively invest might be less prone to bail when the ill winds blow.

Because of changes in index construction mechanics, historical index returns are misleading.

Complete nonsense. One change to one index, 13 years ago, is irrelevant to 90 or so years of market history. Example, the mother of all stock price databases: CRSP US Stock Databases | CRSP - The Center for Research in Security Prices

Informed investors seeking a margin of safety should hunt for stocks that have been largely ignored and excluded by passive index/ETF products, especially those with high insider ownership.

Yup. Sounds great. There are about 10,000 mutual funds, each with multiple stock pickers, almost all looking at the 3600 or so stocks available in the US. What do you think the odds are that there is an "ignored" stock? Zero, maybe? Even Richard Thaler believes that the Efficient Market Hypothesis is a good going-in assumption, though he points out that market prices can be distorted by behavioral factors.

Over the past decade, trillions of dollars have flown out of actively managed equity funds and into passive investment vehicles, most popularly in the form of mutual funds and ETFs that track specific indexes....

Yup. And the people whose paychecks depend on the masses believing the stock picking myth have been fighting and losing the battle. There is absolutely zero data to support the myth. If there were any data they would be pounding us over the head with it. Ergo, there is none. So they are left to tell ghost stories like this guy does.

An implicit ghost story here is the elimination of "price discovery" as the percentage of passive money increases. This little ghost story misses the point that passive funds do not trade. The last statistic I remember is that with 40% of the market cap invested passively, the passive funds comprised less than 5% of daily volume, leaving 95% for "price discovery." And the number of stock pickers will never go to zero, just as casinos and lotteries will never go away. We are wired by evolution to be greedy and optimistic. Our brains actually give us dopamine shots to reinforce this behavior. (Jason Zweig "Your Money & Your Brain")

 

[Chuckanut]

If indexing became 'overloaded' to the point that it started to fail us, then I would expect to start seeing academic papers showing that managed funds that routinely beat the indexes are on the up swing, and at some point the academicians will show that the winning managed funds are the majority or at least a big plurality.

Guys like Peter Lynch and Michael Price aren't a dime a dozen.

 

[Oz investor]

as i see it the main trap with actively managed funds is that they tend to set their own performance benchmarks and those benchmarks can be incredibly low .

many a time i have seen funds claiming 'out-performance ' while achieving negative 'total returns '

now if the fund promoted 'income reliability ' as the main aim , i could live with that but some claim the best looking stat as the headline grabber ( whichever figure that drags in new money )

and of course the promise of 'endless winning years '

index funds promise to keep close to the targeted index , so all they have to do is stay honest

( i hold a mix of shares , and fund styles and don't expect any one investment to gain every single year )

 

[Big_Hitter]

Another reason I have an FA stock picker dude -

+1

 

[foxfirev5]

As mostly an indexer I truly appreciate everyone who has a stock picking FA.

 

[DrRoy]

Back when I had a FA for some of my investments, my largely indexed $ performed better than what he managed, even before the fee. I fired him.

 

[OldShooter]

Back when I had a FA for some of my investments, my largely indexed $ performed better than what he managed, even before the fee. I fired him.

Yes. Nobel prize winner William Sharpe explained that to us in a very readable 3-page paper published in 1991. (https://web.stanford.edu/~wfsharpe/art/active/active.htm) Ken French discussed and amplified in this video: https://famafrench.dimensional.com/videos/is-this-a-good-time-for-active-investing.aspx

"Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs."

Since then, the seminanual S&P SPIVA and Manager Persistence reports have showed us that the stock pickers' results aren't nearly as good as Sharpe's theoretical analysis predicts.