The latest from Michael Mauboussin at Credit Suisse was released this week. The report digs into the important question of how the rise of index funds are impacting the market.
About 39% of AUM (and growing) currently sits in index funds and ETFs. But there is a point where that becomes a problem. Everyone can’t index because then nobody is buying based on fundamentals. So at what level does the balance between active and passive investing lead to an unhealthy market?
Well, Mauboussin and crew, think they have a way to measure it. Or, at least, measure the opportunity in the market, assuming you find an active manager with the skillset to take advantage of it.
In the last 20 years…the trend in gross profit yield has been lower. As a result, investors have lowered their expenses by moving to index funds and ETFs. This raises another question: Are investors indexing because the market is efficient, or is the market efficient because investors are indexing?
Market efficiency is the prime motivation for indexing. This makes sense. But it is important to bear in mind that indexers rely on price discovery, which is a positive externality as a result of active management. The efficient allocation of capital suffers if the very act of indexing creates distortions that cause prices to deviate from fair value.
The second case, that markets are efficient because of indexing, is more subtle. The argument is that less informed investors, be they individuals or institutions, are leaving the active management game which leaves the more informed investors to compete with one another. Said differently, the investors who may have suffered the negative gross profits in years past have departed and the skillful are left to slug it out among themselves.
Consistent with the fundamental law of active management, you want to use an active manager when you feel you can assess manager skill and there is variability in gross profit. Skill without opportunity is futile, and opportunity without skill is wasted.
The idea is fairly simple. If too much money flows into index funds, it could lead to a more inefficient market. Inefficient markets are opportunistic markets for active managers to thrive on. At that point, it’s worth looking into active funds. This should sit well with anyone looking for the best return after fees and taxes.
So all you have to do is pick skilled active managers or be an active investor yourself. Not easy, but possible. And if you fit that description, and want better than market returns, the best place to look is outside the most popular indexes. That means illiquid stocks, small cap stocks, and other stocks not in popular indexes until size (AUM) becomes an obstacle.
Alternately, both active and passive investors can differentiate further with a longer time horizon, concentration, and better behavior.
There’s been a lot of talk about a “bubble” in passive investing. The discussion is good because it’s an important one. Whether there is a real bubble in index funds, I don’t see it (I could blind to it). I don’t see the mania or panic buying you find in previous bubbles.
If I were looking for signs, I’d watch for any change in perception toward index funds and ETFs as “safer”. Index funds are “safer” than active funds only in the risk of underperforming the market. Market risk still exists. You can lose if the market falls.
But what happens when investors start believing that index funds are safer because of “more efficiency” or “less volatility” or “you can’t lose” or whatever reason is used to rationalize safety?
Prices get out of wack when a good idea warps into something different (see Buffett on the housing bubble). It’s a gradual process, but eventually, price action takes over because people ignore the real risk.
If the view “index funds are a good idea because it’s hard to beat the market” warps into something else and prices distort around the new reasoning, then index funds become riskier to own. Maybe it never reaches that point but if it did, it would have to draw alot of “active” money in on the price action (ETFs help that possibility).
Again, I don’t believe it exists today. Besides, bull markets don’t have to end in a bubble.
Today’s behavior fits closer to “what else are you gonna own?” A low rate environment with low return expectations is driving investors into assets they wouldn’t normally own – not out of euphoria but out of necessity (or ignorance).
With investing, you have to do something with the money. You can sit in cash or a money market fund earning next to nothing or you can earn something but at a higher risk. Most people are choosing to earn something over nothing. The question is whether they understand the risks.
Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria. – John Templeton
This bull market may not be euphoric, but some investors are putting money into assets as if risks don’t exist. Should euphoria kick in, it’ll be fun to watch…from the sidelines.
- The Seduction of Pessimism – M. Housel
- I’d Like to Solve the Puzzle, Pat – Reformed Broker
- Still (Not) Crazy After All These Years – AQR
- Why I Quit the Agg, and Why You Should Too – SPDR Blog
- Persistence Of The Value Premium – L. Swedroe
- In Defense of Active Portfolios: Value Investing Works, In Multiple Ways – Globe & Mail
- CAPE Fatigue – Research Affiliates
- Short-Termism Hasn’t Hurt Companies Long Term – N. Smith
- The Behavioral Economics Guide 2017 – BehavioralEconomics
- Inspecting Algorithms for Bias – MIT Tech Review
- Why Higher Education in America is Ripe for Disruption – 13D Research
- The Lost Genius of the Post Office – Politico