Michael Burry, who shot to fame with the movie “The Big Short,” said last August that there is a bubble in the making in the passive investment management industry. Almost 15 years ago, he became one of the first fund managers to spot the overheating mortgage market in the United States, which led him to short billions of dollars worth of mortgage-backed securities through credit default swaps. This unpopular trade netted him just over a billion when the housing market collapsed in 2008. Because of this reputation, investors pay close attention when he has something to say about capital markets.
In an e-mail response to Bloomberg, Burry wrote:
“The bubble in passive investing through ETFs and index funds as well as the trend to buy very large size companies among asset managers has orphaned smaller value-type securities globally.”
Clarifying further on this, he said active investing has almost gone out of fashion with the exponential growth of index funds.
The latest guru to criticize this billion-dollar industry is Ariel Investment’s Rupal Bhansali. She is considered one of the top brains in Wall Street today and is a member of the prestigious Barron’s Roundtable, which features the top ten thought-leaders in the industry.
In a blog article published on Ariel’s website in January, Bhansali wrote, “I have nothing against passive funds but investors have been treating it like a miracle cure. You don’t have to work hard at anything, just put your money to work and its low cost so it’s off to the races.”
After discussing in detail the active strategies she uses to find mispriced bets in the market, the Guru made a case for choosing active investing, even though such techniques have lagged the market of late:
“Markets don’t reward you just because you’re big – I’ve never heard of that. What markets reward is any strategy that creates a fair price for security. A fair price is the intrinsic price of a business at which neither buyer nor seller makes a profit or loss when you’re converting an asset into cash and cash into an asset – that’s a fair price and that’s what markets reward. That is why non-consensus investing works because not only do I reduce price distortion I contribute to fair price discovery. I get doubly rewarded and that’s your upset victory.”
She concluded the discussion by claiming that passive investing is not even a strategy as it does not involve any deep research of company fundamentals.
Investors who follow gurus for investment advice might find themselves in a tricky situation. As many are aware, the legendary Warren Buffett (Trades, Portfolio) has, on many occasions, said that buying an index fund should be the first investment of an investor and that it could deliver very attractive returns. The subject matter of this analysis is to compare both these opinions and determine what’s best for investors.
The secular growth of passive funds
In September 2019, assets managed by passive funds surpassed active funds for the first time in history. This didn’t come as a surprise, as there has been a surge in the popularity of low-cost investment options since the days of the financial crisis.
Source: Bloomberg
According to data from Morningstar, there are a few reasons behind this development:
- Lower costs in comparison to buying equity securities or active funds.
- The underperformance of active managers since the market crash in 2008.
- The hectic lifestyles of the new generation of professionals that do not allow them to do the necessary research to pick stocks after thoroughly studying the fundamentals of a company or industry.
- Lower risk resulting from gaining exposure to a basket of stocks through one single investment.
Morningstar senior analyst Kevin McDevitt told Bloomberg in September, “Investors are far more tolerant of passive products, partly because of how they’re investing. It’s kind of a set it and forget it kind of thing.”
The real question, however, is whether investors can, indeed, invest and forget about it with these types of investments. Bhansali certainly doesn’t think so, at least not when it comes to long-term investments.
A comparison of performance
Index funds have outperformed their active peers in the last 10 years by a healthy margin, as illustrated in the below chart.
Source: Hartford Funds
However, it seems as if investors are not looking at the big picture, which has historically proven to be a costly mistake. As evident from the above illustration, this outperformance of passive strategies comes on the back of a sustained period of alpha returns provided by active strategies. It’s evident that there’s no clear winner in the long term, and that this trend is cyclical, which means that today’s winner might not be tomorrow’s winner.
However, many investors only look at the time period since 2008 and jump to the conclusion that picking stocks is dead and that it’s better to go with the crowd.
There’s another important piece of data that investors might find useful before making investment decisions. FactSet, after analyzing market performance data during 26 corrections going back to 1987, came up with the below results.
- Active wins: 19
- Passive wins: 7
- Average outperformance: 1.48%
This goes on to reveal that active strategies have historically weathered turbulent market conditions much better, possibly due to the quality of fund managers who vet each and every investment thoroughly before including them in a portfolio.
The U.S. markets are in a massive bull run that has lasted over a decade. This has immensely helped index funds as almost all stocks have appreciated, even the ones with weak fundamentals. However, things won’t stay the same forever, and as empirical evidence suggests, active might come on top during the next recession.
The key is to track the performance of both these techniques in full business cycles rather than to look at limited numbers that would give misleading information. Rupal Bhansali is looking at the long-term view.
Warren Buffett (Trades, Portfolio) is an active investor
Even though the Oracle of Omaha has advised investors to use index funds in their early days, he only invested in such a security for the first time in the fourth quarter of 2019, after more than 50 years since he took control of Berkshire Hathaway.
According to data from Reuters, the book value of Berkshire has grown at a faster rate than the market, and the company's shares have outperformed the S&P 500 Index over the long term as well. If the guru did not deploy active strategies, the performance would have been identical to that of the broad market. The alpha he generated was a result of carefully evaluating prospects for undervalued companies and their management and investing when other market participants were reluctant to do so. All these principles are at the core of active strategies.
His advice to consider index funds is geared toward investors who are neither committing money nor time to study companies and markets in depth. However, as most readers on GuruFocus are serious about investing and generating better-than-average returns, it seems best to listen to Bhansali.
Index funds might be best for diversification purposes
One of the biggest benefits of index funds is that they provide exposure to a large number of stocks in a certain industry, business sector, or even the entire market at a very low cost. Combining carefully selected equity securities with a passively managed fund could help diversify an investor's portfolio, which is essential to generating sustainable returns in the long term. Therefore, investors should ideally try to strike a balance between the two strategies to improve the chances of building a portfolio that will deliver positive returns in all market conditions.
Takeaway: it’s the big picture that matters
According to available historical data, Bhansali is right on the point. The performance of the last decade has skewed the statistics in favor of passive strategies, which is misleading as it conceals the cyclical nature of outperformance between active and indexing techniques. Even though a full-blown recession is unlikely to occur this year, global growth will likely slow down, which could become a good platform for active investing to gain an edge. A decision by an investor to embrace one of these strategies should reflect his or her knowledge of capital markets, investment time horizon, objectives and risk tolerance.
Disclosure: I do not own any stocks mentioned in this article.
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