By LARRY SWEDROE
Passive bubble.
The active investment management community has been attacking indexing—and passive investing in general—for decades. The reason is obvious: its profits (and for many firms, their very survival) are at stake. The attacks began almost from the moment John Bogle started the First Index Investment Trust (later renamed the Vanguard 500 Index Fund) on December 31, 1975. At the time, competitors uniformly derided it, even calling it “un-American” and “Bogle’s folly.” Now-retired Fidelity Investments Chairman Edward Johnson was quoted as saying he couldn’t “believe that the great mass of investors are going to be satisfied with receiving just average returns.” One of the great ironies is that Fidelity is now one of the leading providers of index funds. It was also the first fund family to offer a zero-expense-ratio index-based ETF.
The criticism reached an absurd level when a team at Bernstein called passive investing “worse than Marxism”. The authors of the note wrote: “A supposedly capitalist economy where the only investment is passive is worse than either a centrally planned economy or an economy with active market led capital management.”
The latest assault comes from Michael Burry of The Big Short fame. Burry declared that indexers caused a bubble. Given the accuracy of Burry’s previous forecast of a bubble in mortgages, I was not surprised to receive emails from advisors and investors alike, so I thought I would share my thoughts on the issue. Passive bubble.
I’ll begin by noting that Burry is not the first to claim that indexing has created a bubble. Another example of such criticism was the article What They Don’t Tell You About Passive Investing. Produced by Morgan Stanley, the thrust of the paper was that “the exodus from active to passive funds may be reaching bubble-like proportions, driven by an exaggerated critique of active management.”
The basic argument of these and other critiques is that the popularity of indexing (and the broader category of passive investing) is distorting prices, as fewer shares are traded by investors performing the act of “price discovery.” Let’s examine the validity of such claims.
To start with, the trend is from actively managed funds to passively managed funds. Consider the institutional world, where pension plans and endowments allocate capital across asset classes/investment strategies. While the persistent failure of active management (see the latest SPIVA results summarised here) has fuelled the trend to passive strategies, all that is happening in most cases is that some active manager was fired and replaced with an index or otherwise passively managed fund in the same asset class. And because, in aggregate, the active managers basically hold the same stocks in the same proportions as the index fund they are replaced by, there should not be any impact on prices. This is true no matter the asset class, since all stocks in an index must be owned by someone, and institutional investors now hold the vast majority of stocks. Individual investors hold a small minority in their brokerage accounts. (The one exception is what are called “lottery stocks”, which have very poor returns. Institutional investors tend to underweight these stocks, while individual investors overweight them.)
In addition, remember, passive investors are price-takers (accepting the market’s price as the best estimate of the right price). It’s the actions of active managers that set prices. (Note that it is true that when an index fund receives a large cash flow, the fund managers tend to buy or sell at the close. With a large enough flow, they can move prices—especially because of their desire to track the index as close to perfectly as possible. In those cases, they become liquidity-takers. These weaknesses of pure indexing can be minimised with the use of patient algorithmic trading). Passive bubble.
Burry also said: “The bubble in passive investing through ETFs and index funds as well as the trend to very large size among asset managers has orphaned smaller value-type securities globally.” While it is certainly true that a trend to large growth investing (or almost any asset class) can lead to a bubble (as in the late 1990s), that has nothing to do with the trend to passive investing. As an example, there are plenty of passively managed small value funds, including Vanguard Small-Cap Value ETF (VBR, with about $13 billion in AUM) and Vanguard Small-Cap Value Index (VISVX, with about $29 billion in AUM). Other small value ETFs include iShares S&P Small-Cap 600 Value (IJS, with about $6 billion in AUM), and iShares Russell 2000 Value (IWN, with about $8 billion in AUM). And then there is DFA U.S. Small-Cap Value Fund (DFSVX, with about $13 billion in AUM). Together, just these five small value funds alone have almost $70 billion in assets under management. That hardly seems to fit the category of orphaned. (Full disclosure: My firm, Buckingham Strategic Wealth, recommends Dimensional funds in constructing client portfolios.)
The irony
What’s really ironic about the criticisms aimed by active investors is that if indexing’s popularity were actually distorting prices, active managers should be cheering, not ranting against its use, because it would provide them easy pickings, allowing them to outperform. (Note that if money flowing into passive funds distorts prices, it could still make it difficult for active managers while it is occurring because distortions could persist as long as the flow continued. Eventually, though, the opportunity would manifest itself.) Here we turn to our trusty videotape to demonstrate that the exact opposite has been occurring—the rise of indexing has coincided with a dramatic fall in the percentage of active managers outperforming on a risk-adjusted basis.
As one example of what my co-author Andrew Berkin and I called The Incredible Shrinking Alpha, the study Conviction in Equity Investing by Mike Sebastian and Sudhakar Attaluri, which appeared in the Summer 2014 issue of The Journal of Portfolio Management, found that the percentage of skilled managers was about 20 percent in 1993. By 2011, it had fallen to just 1.6 percent. This closely matches the result of the 2010 paper “Luck versus Skill in the Cross-Section of Mutual Fund Returns.” The authors, Eugene Fama and Kenneth French, found that only managers in the 98th and 99th percentiles showed evidence of statistically significant skill. On an after-tax basis, that 2 percent would be even lower. Passive bubble.
In our book The Incredible Shrinking Alpha, Andrew Berkin and I present evidence as well as the reasons for the dramatic decrease in active investors’ outperformance on a risk-adjusted basis.
In addition to the evidence on the failure of active management to persistently generate risk-adjusted alpha, it’s easy to check whether increased flows to index funds are causing price distortions. If that were the case, all securities in an index would be rising/ falling by about the same percentages as cash is invested based purely on market capitalisation.
As pointed out in my annual look at lessons the markets teach investors, the S&P 500 Index lost 4.4 percent in 2018, including dividends. In terms of price-only returns, 10 stocks were up at least 42.6 percent. On the other hand, the 10 largest losers lost at least 44.2 percent. All active managers had to do to outperform was overweight the top 10 and underweight the bottom 10. Or they simply could have held cash! Yet Vanguard 500 Index Investor (VFINX) outperformed 71 percent of actively managed funds in its asset class. 2019 is no different. Through August, the S&P 500 Index was up about 17.5 percent in terms of total return. According to S&P, 10 stocks returned at least 62.1 percent (led by the return of 94.2 percent by Chipotle), and 10 stocks lost at least 37 percent, the worst performer being Dupont, with a loss of almost 58 percent. The gap between the top and bottom performers was 152 percent, presenting active managers with a great opportunity to add value. Demonstrating how absurd the criticism of passive investing is, if it were driving prices and destroying the price-discovery function, we would not have seen such wide disparity in returns. Clearly, active investors engaged in price discovery are still trading, and their activity must be what is setting prices. And again, VFINX outperformed about two-thirds of the actively managed funds in their asset class.
One final example. Every day on cable financial news networks, we observe how stock prices jump (decline) immediately after companies announce better-than-expected (worse-than-expected) earnings. Because index funds do not trade at all on earnings announcements, it must be the price-discovery actions of active investors moving prices, correcting the prior prices to account for the new information. Just how quickly prices adjust is testament to the market’s efficiency.
Summary
As sure as the sun rises in the East, the proponents of active management will continue to attack passive investing. In almost every case, these attacks not only are without foundation, they are also absurd, and easily exposed as such. But that doesn’t stop them. The reason is simple: passive investing threatens their livelihood. Thus, their behaviour should not come as a surprise.
Postscript
While I don’t agree that the trend toward passive management has orphaned small value stocks, as Burry claimed, their underperformance over the past few years has widened the spread between valuations of growth and value stocks. And wider spreads tend to forecast larger premiums. Of course, just as in the late 1990s, cheap stocks can get even cheaper. Thus, if you are going to invest in small value stocks, make sure you have the discipline to stay the course.
LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of 17 books on investing, including Think, Act, and Invest Like Warren Buffett.
Larry is a regular contributor to TEBI. Here are some of his other recent articles:
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