“Today, familiar patterns are emerging that should get us thinking about a possible financial bubble in passive investing, largely because money is being directed to passive investment vehicles rather than thoughtfully invested.” –Â Charles Brandes
A growing minority of the investing world believes in passive investing and is rapidly transitioning from active management to passive management, using mainly indices (or indexes).
Essentially, those investors believe there are few differences between active and passive so they might just as well use passive funds and save a point or two on expenses. As for risk, these investors generally believe the risks are similar.
But guru Charles Brandes (Trades, Portfolio) challenges the assumption that passive funds are as safe as active funds. Does he have a case?
Who is Brandes?
Born in Pittsburgh, Brandes graduated from Bucknell University in 1965 with a degree in economics. He then went on to graduate studies at San Diego State University.
While training to be a stockbroker in San Diego, he met value investing guru Benjamin Graham and learned Graham’s techniques firsthand from the master. That included research to identify undervalued securities.
He quickly went out on his own in 1974. And, as ValueWalk reports, he started out with the moral support of Graham; in a personal letter to Brandes, Graham sent his best wishes and wrote, “I'm confident that your partners will be well pleased with the results.”
According to its website, Brandes Investment Partners currently has $29.7 billion of assets under management.
Brandes and a passive investment bubble
The guru starts his analysis by making a distinction between "directed" investing and "thoughtful" investing. In his article “Passive Investing: Another Financial Bubble?” Brandes explores the difference between the right kind and the wrong kind of investing, and how the wrong kind could be creating a bubble.
Directed investing means putting money into index funds without carefully considering the stocks or securities within the mutual fund or ETF. For example, how many benchmark investors can name the heaviest weights in the SPDR S&P 500 (SPY, Financial)? If the big names are tech companies, that means one thing; if they are consumer defensive stocks, that means something entirely different. As we know, of course, the SPY will contain both of the above, and a lot more sectors as well. So, as a whole, what does that mean for volatility and valuations? What are you really buying when you buy a passive fund?
On the other hand, thoughtful investing refers to individual stocks and portfolios chosen by active managers. Individual securities are added and taken out of the portfolio for a specific strategic reason, and those securities should complement each other in a way that serves a broader strategic need among fund holders. Portfolios might aim to preserve capital, generate income or build on capital gains. A thoughtful investing process should pull all the elements into one coherent strategy.
Brandes goes on to argue that, despite an increasing sophistication among investors, financial bubbles can and will continue to occur. The result? Financial and psychological harm. If we knew bubbles were forming, we would likely avoid them. But Brandes says we can’t escape them.
The problem, he says, is that would-be bubbles are ignored because "it is different this time." It's only after a bubble bursts that so-called experts can then make the diagnosis. Despite that pessimistic prognosis, Brandes says bubbles exhibit "remarkable" similarities: They tend to occur when prices become uncoupled from intrinsic value.
To tie the bubble phenomenon back to passive investing, think of the billions of dollars flowing into index funds, of being "directed" to the funds. Stocks in the indexes are being pushed up because they happen to be in the indexes rather than for their intrinsic value. Brandes notes the cap-weighting methodology used in many passive strategies can distort the valuation of larger-cap securities because they receive proportionately higher allocations than intrinsic value would suggest.
Further, he writes, investors used to buy businesses and compare their performance with benchmarks. Now, that’s no longer the case for two reasons: First, because investors have become sensitive to fees, and second, because they focus more on short-term results.
Brandes says the promise of lower fees and a short-term perspective has meant extraordinary growth in passive investing. He cites data showing passive funds in the U.S. took in $506 billion in 2016 while actively managed funds suffered $341 billion in withdrawals.
This rush to passive investing could create a bubble because of the accelerated growth in valuations based on "directed" investing rather than 'thoughtful' investing.
Given this existing scenario, he asks two questions: “What might make a bubble burst?” and “What happens if it does pop?” Brandes observes all bubbles collapse when the market discovers the disconnect between prices and actual market values. As to the second, he speculates it could lead to "vast sums" of capital pulling out of the market, driving share prices sharply lower and potentially creating liquidity problems.
Brandes’ solution
Not surprisingly, the guru thinks the way to head off bubbles, or to avoid being caught up in them, is to reverse the trend away from active managers.
That also means finding the right active manager or managers. Brandes offers several suggestions to help find that "right" active manager, including a focus on managers with more than 20 years experience.
Brandes also points to the concept of Active Share. That refers to an academic study by Martijn Cremers of the University of Notre Dame and Antti Petajisto of LMR Partners. It makes a distinction between the most active stock pickers and those who are considered closet indexers.
The authors found that the most active stock pickers beat their benchmark indices (after fees), and closet indexers underperformed. They say this differential held up in both bull and bear markets since 2007 (including the 2008 crisis).
Behind that finding lies willingness to deviate from the benchmark; the more active managers deviated further and were rewarded with alpha. In further research, Cremers also found that active stock pickers with long-term conviction outperformed those with shorter-term horizons and less conviction.
Brandes, Dodge & Cox
The case for active investing made by Brandes parallels that made by Dodge & Cox on activist investing. In “Understanding the Case for Active Investment”, an internally researched and published paper, Dodge & Cox argues on many of the same grounds.
That includes a belief in long-term perspectives and active share. Like Brandes, Dodge & Cox cites the same academic research (Cremers and Petajisto) to argue that the most successful active investors are those willing to deviate most from the benchmark.
Conclusion
Brandes offers a good case for a passive investing bubble, one which might burst with a bang that will hurt those who have tied their capital to a benchmark.
Even if we do not accept his reasoning or his conclusions, his analysis of "directed" investing and "thoughtful" investing deserves attention. It’s also worth asking if active managers are also guilty of directed investing at times, as they stay close to the benchmark to avoid losses greater than those of the benchmark.
And we should ask if active managers can escape unscathed if the passive bubble (assuming there is one) collapses. Given the current scope and depth of passive investing, it seems likely active managers may be pulled down with the passive investors. Many active managers, including Brandes, suffered major losses in 2008; he lost more than 55% when the housing bubble collapsed.
Disclosure: I do not own shares in securities listed in this article and will not buy any in the next 72 hours.
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