Index funds have enjoyed a massive surge in popularity over the last decade. The idea of replicating the market return, or some component thereof, was once considered a poor investment compared to canny active management. But years of anemic returns from hedge funds and mutual funds, accompanied by the upheavals of the financial crisis, have convinced an increasingly large number of investors and allocators to bet on passive strategies.
The low-fee nature of index funds is certainly laudable; we have dedicated a number of research notes to the subject of fund fees and why they are often absurd. But the flood of capital into index funds may have created problems of its own. Indeed, we may actually be in the midst of a passive investing bubble.
Asking the wrong question
There will always be winners and losers among active managers. Thus, the combined performance of managers trying to beat the market will almost always come up short of the performance of the market as a whole. Passive strategies like index funds are meant to mimic a safe return in the knowledge that picking an active manager can result in suboptimal outcomes by comparison – even if it means forgoing the opportunity for abnormal returns thanks to successful active management.
A report by INTL FCStone (INTL, Financial) offers one of the best encapsulations of this thinking, and why it may be faulty:
“The active-versus-passive debate is going nowhere because it focuses on the wrong question: the active sector as a whole will always underperform a comprehensive, market-cap weighted index by the amount of management fees. The managers who are expecting passive funds to underperform are fighting mathematics.”
In other words, the debate between the aggregate returns of active managers and passive index funds is not thinking in the right terms. But that tells us nothing about a potential bubble. What we need to know is how passive funds affect the market.
Not so passive
As stated before, passive funds work by replicating the market return, or some component thereof. But index funds may not be so passive after all. Indeed, data now suggests that index fund composition is having a material impact on underlying stock prices.
The INTL report points out that the average U.S. stock is part of 115 indexes. That is not terribly interesting in and of itself. This is the real kicker: Stocks in more than 200 indexes are 2.5 times more expensive than stocks in fewer than 75 indexes.
So stocks that are in high demand among indexes are more expensive than those that are not. But what does that mean? For one thing, it indicates quite clearly that index fund composition and design is genuinely impacting stock prices.
The danger is real
The INTL report has this to say about this worrying trend:
“Price discovery would be impossible in a fully passive world. The more interesting question is whether we have reached this passive tipping point…Index funds are no longer passively replicating capital markets, but that they are transforming them in a possibly less efficient manner.”
So we have a market in which an increasingly large percentage of invested capital is pouring into index funds. These funds affect stock prices since the demand for the underlying stocks is determined increasingly by the needs of each index to incorporate them. Stocks needed for more indexes face higher demand by the index funds, bidding up prices. Meanwhile, stocks in fewer indexes face far less pressure.
The danger is this: Investors allocating to passive funds expect performance that mimics the market, but the insatiable demand for exposure to such funds has itself divorced some of these indexes from the underlying financial realities. That may not be a huge problem in a bull market, but it could have destructive knock-on effects in a downturn.
Looking for an out
Following the tide of the market may have worked historically over a long period of time, but corrections do happen. Investors buying now are not buying cheaply. A correction could result in years of hurt. Index funds will likely never disappear, but their current extreme popularity is the product of a remarkable bull market, not a long-term view of averaged returns.
Investors may be aware of the problem, but not necessarily know what to do about it. In the case of a passive investment bubble, there may be few good places to hide when it pops. These are investors and allocators skeptical of active management, so finding an alternative to index funds could prove very challenging.
Where should investors look?
Value may be the key
Many investors and institutions are falling into a passive allocation trap. Savvy value investors will know better than to follow their lead.
While prices remain high across the board (and may continue to do so even after a passive shakeout), it is increasingly clear that value-oriented active strategies represent a good play. Deep value will be of particular utility. Investors can find under-indexed stocks that are good companies but have not been bid up by the insatiable demand of index funds.
Under-indexed value and deep-value stocks could prove to be real winners in the event of a correction, or simply cheap value in the face of high prices if the bull run continues.
Disclosure: I/We own no stocks discussed in this article.
