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John Engle
John Engle
Articles (613) 

Index Funds Ignore Bubbly Valuations at Their Peril

Indifference to valuation multiples is leading passive capital toward a cliff

January 31, 2021 | About:

Since the end of the Great Financial Crisis more than a decade ago, the rise of passive investing strategies has represented one of the clearest, and most enduring, macro trends shaping capital markets. Around $4.6 trillion is now indexed to the S&P 500 alone, a truly staggering total that does not even account for the additional $6.6 trillion that is benchmarked to the popular index.

Historically, index fund managers have tended to avoid discussions about specific companies, especially when it comes to questions about individual stock valuations. However, while such a policy of salutary neglect may have worked in years past, it now looks increasingly untenable.

Dangerous indifference to value

If passive capital flows have a material impact on the prices of individual securities, then they must also have a material impact on the efficiency of the price discovery process. Unfortunately, index fund managers are generally barred from taking action to address such distortions since they are mandated to "own the market" as defined by their particular benchmarks irrespective of price. That can have troubling consequences, as hedge fund manager David Einhorn (Trades, Portfolio) pointed out in his January investor letter:

"Index funds are the most obvious valuation-indifferent investors. In fact, to the extent a stock is overvalued, index funds are required to buy even more of it."

In other words, index funds do not care particularly about the valuations of the various stocks in their portfolios because their portfolios exist solely to mirror a basket of stocks as defined by the indexes to which they are linked.

The consequence of this, as Einhorn observed, is that index funds' rebalancing efforts can end up exacerbating and reinforcing irrational price movements, whether rallies or routs.

Sleepwalking toward trouble

The problems have only gotten worse over the past year, according to another top hedge fund manager, Seth Klarman (Trades, Portfolio) of the Baupost Group. In his recent annual letter to investors, Klarman decried the Federal Reserve's unprecedented decision to prop up capital markets at all costs, which he argued had triggered a speculative frenzy:

"The more distant the eventual pay-off, the more the present value rises. When it comes to the value of cash flows, the vast and limitless future, yet to unfold, has gained considerable ground on the more firmly anchored present."

According to Klarman, stocks such as Tesla Inc. (NASDAQ:TSLA) have become unmoored from the mundane reality of today in favor of dreams of tomorrow thanks to the Fed's actions, which have "directly contributed to exceptionally benign market conditions where nearly everything is bid up while downside volatility is truncated."

Having been added to the S&P 500 index late last year, Tesla is an ideal example for the purposes of this article as well, since, as I observed at the time, index inclusion has exposed a far wider number of investors to the volatile stock. With such a name now a top component of the world's most widely followed index, remaining valuation-indifferent may prove increasingly tough for some index fund managers.

My verdict

Ultimately, while active investors can get along just fine in the absence of passive investors, passive investors cannot survive in the absence of active investors. If index fund managers persist in their indifference to valuations, disciplined active investing strategies, as well as more hands-on index selection, may once again shine.

Disclosure: Author is short Tesla.

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About the author:

John Engle
John Engle is president of Almington Capital Merchant Bankers and chief investment officer of the Cannabis Capital Group. John specializes in value and special situation strategies. He holds a bachelor's degree in economics from Trinity College Dublin, a diploma in finance from the London School of Economics and an MBA from the University of Oxford.

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