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New Moon
New Moon
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Positive Feedback Loop of Passive Funds

The popularity of passive funds may have changed the market paradigm

November 01, 2017 | About:

The stock market keeps reaching new highs and passive fund inflows have also reached new highs. According to FactSet data, the total exchange-traded fund (ETF) inflow has reached $369 billion year to date, a new annual record with two months left in 2017. At the same time, the actively managed equity funds and hedge funds continue to suffer outflows due to poor performances. Anecdotally, even some of the best value fund managers have suffered. The Wall Street Journal reported David Einhorn (Trades, Portfolio)'s Greenlight Capital had a 15% redemption in mid-year 2017. CNBC further added the fund was down 0.2% through July versus the Standard & Poor's 9% return. Bill Ackman (Trades, Portfolio)'s Pershing Square was up 0.9% year to date through July.

For the moment, it felt as if, universally, active money management was dying.

The average Joe, who is so busy with his work, his family and his hobbies, understands the appeal of passive funds. By buying into an index, he theoretically enjoys the performance of the whole market without having to do much work. Of course, there have been tens and even hundreds of news reports correctly pointing out, from time to time, the majority of actively managed funds underperform market indices. Bingo. Without doing any work, one can actually ride the stock market waves without an expensive financial education. That is a no-brainer.

In the beginning, actively managed funds underperform the market indexes for several reasons. First, indexes do not hold cash. In a rising market, cash can easily become a drag for actively managed funds because they have to hold some level of cash (note we are in a very long bull market).

Second, indexes have "survivor bias" because the weaker companies are periodically replaced by better ones. Therefore, it has been discovered that, overall, many active managers underperform the indexes, particularly in recent years.

Third, people have discovered passive funds have low fees. Passive funds perform trading via a computer that calculates the weights of stocks and a few other things. In comparison, active funds are managed by humans performing complicated research. To cover the whole spectrum of stocks, the funds need a lot of manpower. There is little chance actively managed funds win on the cost side, especially when the funds are large in scale.

As passive funds become more popular, there are increasingly more advantages for passive funds to outperform. This is what I call a positive feedback loop. Passive funds form their portfolios by using the market value of stocks. Every day, the top-performing stocks have the biggest percentage increase in market value. The worst-performing stocks have the biggest percentage decline. Therefore, the money flows to the outperforming stocks from the underperforming stocks.

For example, assume only two companies form the whole market, CUTE and LOVE. They start with a market value of $100 billion each. There is an index ETF that is 30% of the market, or $60 billion (30% * ($100 billion + $100 billion)) in assets, with $30 billion in CUTE and $30 billion in LOVE. CUTE's price is up 50% and LOVE's price is down 50%.

CUTE now has a market value of $150 billion and LOVE has a value of $50 billion. The weight of the index ETF needs to reflect the change in market weights of CUTE and LOVE from 50-50 to 75-25. With a fund size of $60 billion, its position in CUTE needs to increase from $30 billion to $45 billion, and the position in LOVE needs to decrease from $30 billion to $15 billion. So the next day, CUTE has a mechanically created demand of $15 billion and LOVE has a mechanically created supply of $15 billion. Unless the remaining 70% of the market moves drastically in the other direction, chances are CUTE will continue to outperform LOVE. As a result, LOVE becomes increasingly unloved.

Therefore, intuitively, the passive funds have a buy high, sell low strategy. They mechanically buy more outperforming stocks and sell more underperforming stocks in the process of rebalancing the portfolio according to the market weights of companies. Accounting for about one-third of the market, they created what is akin to a positive feedback loop. The outperforming stocks tend to get more inflows and, therefore, continue to outperform. The underperforming stocks do just the opposite.

This creates a very difficult situation for active managers, particularly value managers. The idea is that, everything being equal, one should trim outperforming stocks and add to underperforming stocks. A share is a piece of a businesses and, therefore, the stock's price should converge to its intrinsic value. But the increasing size makes passive funds have incremental power to create demand for stocks according to a formula that completely overlooks the intrinsic value of stocks.

I hope this problem will eventually be addressed. For now, even good investors like Einhorn are wondering "if the market has adopted an alternative paradigm for calculating equity value."

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Rating: 4.0/5 (4 votes)



Gurufocus premium member - 2 years ago

Very good explanation!

Crafool - 2 years ago    Report SPAM
Good article. I would add the fact that Warren Buffett (Trades, Portfolio) likes to say “Markets aren’t here to guide you, but serve you. You are not right because the market agrees with you, but when and only when your research is right.” Indexes are a mistake in setting values for companies as passive indexing is in today’s environment more of an exercise in “hacking” game theory. Yes there are tons of articles stating the out-performance of passive indexes over active managers. This is true as each dollar added to an index fund supports that index and drives prices for those companies higher, but this is like a “hack” in a game in my opinion. Yes, if the game is rising prices, it is a good hack, but it is a dangerous hack. One day, the companies that make up these indexes will revert to their real economic values or more likely the investors or speculators in the index will want to gain real value from their game theory accounts and the dollar support will reverse and work in the opposite direction and speculators will quickly find out they were playing a game and not investing.

In my opinion, investing is about earning the best risk adjusted returns and not about just beating an index.” People will learn this the hard way.

LwC - 2 years ago    Report SPAM

“The average Joe, who is so busy with his work, his family and his hobbies, understands the appeal of passive funds.”

Yes, that is the reality. And one might add that the average Joe simply does not have the aptitude, attitude and knowledge that most of the active “value” investors who frequent this forum, have (or think they have.) IMO it’s important to acknowledge this reality.

Most people who are saving for retirement over years and decades (which according to news reports, is not a high proportion of the population) not only don’t have the time but also are not competent to research stocks, or to pick an active manager who is likely to beat the broad market index fund over the long term. Many of them understand that about themselves, and therefore understand the appeal of passive funds. So, many passive investors are being wise by staying within their circle of competence.

It appears to me that many of the detractors of broad market index funds are simply talking their book. They are investment managers, analysts, promoters and cheerleaders who make their living enticing ignorant investors into high cost investments/funds that almost certainly will not beat the broad market index fund over the long term.

Many investors will earn the best risk adjusted returns over the long term by accepting the broad market index fund performance. People often learn this the hard way.

Thomas Macpherson
Thomas Macpherson premium member - 2 years ago

Great stuff New Moon. Very well written, concise, and easy to understand. That's the perfect trifecta in my book. LwC: thought your's was a great comment. Best - Tom

New Moon
New Moon premium member - 2 years ago

Many thanks for your kind and insightful comments. And appologize for not replying timely enough. Somehow I don't receive emails after you posted your comments. It has been an on-going issue.

While we cannot blame average Joe's behavior and their impact on index funds, which in turn impact market in a very signficant way, I think this could have exagerated the magnitude and duration of trends but not necessarily reduce the force of coverging to the intrinsic value over long term. The investors in this forum first believe that stocks are not just numbers but pieces of underlying businesses. If that holds true (how could that not be?), the rule of economics will ultimately provail, or I hope. We just need to balance the short term trading and long term value.

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