If investors continue to pile their money into passive index-tracking, at some point markets will stop doing their job of allocating resources efficiently in the economy. Perhaps they already have.
The threat is big enough that the world’s largest pension fund is preparing to put more of its money with active managers—who charge more and on average underperform—in an attempt to keep markets functioning properly.
Hiromichi Mizuno, chief investment officer of Japan’s $1.4 trillion Government Pension Investment Fund, worries that market efficiency will be damaged by the rise of passive funds, which rely on trading by active investors to set the price of stocks. Since the signals from market prices are vital to determining the movement of capital around the economy, less efficient signals would hurt growth and lead stock indexes to rise by less than they otherwise would.
“We are long term and a universal owner so we need to make sure that the market will continue to be efficient,” he said.
The problem crops up again and again in finance. It makes sense to be a free rider on someone else’s work, but once everyone realizes that, there is no one left to do the work. In markets, the work is identifying which companies will do best, which harnesses greed to deliver the social goal of divvying up resources for their best use. Unfortunately, the work isn’t just hard, it is zero-sum: for every investor who beats the market by $1, someone must underperform by $1. Why bother when it is easier and cheaper to buy an index? (click on image)Turning to Indexes / Index trackers as percentage of U.S. domestic mutual fundsSource: Investment Company Institute
Those who dislike markets may respond that markets often fail to allocate capital to the right parts of the economy because of bubbles and busts, and they have a point. But even worse is to not even try; as AB Bernstein analyst Inigo Fraser-Jenkins memorably put it a year ago, “passive investing is worse than Marxism.”
For now there is little sign that the U.S. is suffering much, if at all, from the rapid rise in index funds. Jack Bogle, who as founder of index-fund manager Vanguard did more than anyone else to boost indexing, points out that there has been no breakdown in the link between the stock prices of S&P 500 companies—where indexing is much more popular—and the rest of the market. If indexing were truly affecting prices, there should be a greater impact on those with more index-fund ownership, and so a change in their relationship with less-indexed stocks.
“So far it looks like the market system’s working pretty well,” Mr. Bogle said from his holiday home in the Adirondacks. “When [passive] gets to 50% I might want to think about it a little more but I just don’t see that the problem is even on the horizon.” (click on image)
In the U.S., that is true, with credit rating agency Moody’s Investors Service calculating that 29% of assets under management in the U.S. are now passive. But the share is rising rapidly: Moody’s reckons that index funds will take a majority of the market by 2024.I've already discussed the $3 now $4 trillion dollar shift in investing. Jack Bogle isn't as well known as investment all stars like Warren Buffett and George Soros and other top fund managers I track every quarter, nor has he amassed their wealth. But there's no arguing he's the most important person in the investment world by making passive investing accessible to everyone and demonstrating the advantages of low-cost exchange-traded funds (ETFs).
Japan is further advanced in the move to passive investing, in part thanks to the Bank of Japan, which owns Y14.9 trillion ($135 billion) of exchange-traded funds tracking Japanese indexes and has bought another $4.3 billion worth already this month.
Mr. Mizuno thinks GPIF—known as “the whale” for its size—will be emulated by others in Japan. He’s also putting more effort into choosing the best active managers, beefing up the selection team in the hope that the higher cost of active management will be offset by their beating the market, something impossible for all active managers taken as a group.
But it will take time to make a difference. GPIF’s Japanese equities are now 91% passive, counting money in so-called smart-beta funds that follow rules such as value or momentum trading.
So far, big investors elsewhere are showing little concern about the damage passive investment might one day do to the market economy. They’re probably right to think that they can free-ride on active managers for several years yet. But no one knows at what point markets will be impaired, or even how we will be able to tell.
Elroy Dimson, a finance professor at London Business School, said that in previous decades academics also fretted about the growth of passive management and postulated critical levels beyond which it would impair the market. Yet we’ve zoomed passed them, without any obvious signs of trouble. “It’s plucking numbers out of the air” to put a figure on it, he said.
The uncertainty in itself is a reason for caution. Perhaps the market economy could work well even if only a few hundred active investors were involved in setting prices, but I suspect not. The point of tapping the wisdom of crowds is that it needs a crowd, and the smaller the crowd is, the less effective it is likely to be.
It is time other big investors starting thinking like GPIF, because if the rise of passive does undermine economic growth, it will do a lot more damage to their portfolios than a bit of active underperformance.
There is a simple question that every investor needs to ask: why invest in mutual fund A or B, or worse still, hedge fund C and D or private equity fund E and F, if they can get the same or higher returns over a long period at a fraction of the cost simply by investing in the S&P 500 ETF (SPY) or even a basket of ETFs that are rebalanced every year or following a simple rule?
The rise of robo advice is a direct extension of this question. "Sophisticated" Millennials have figured it all out, no more worrying about mutual funds, just plug in your risk tolerance here and get a tailored portfolio of low-cost ETFs which are rebalanced every year or following some simple rule. They can even track everything on their cell phone in between posting silly pics on Instagram and Facebook.
Unfortunately, this electronically-lobotomized generation which is rewriting the rules on what a pathetic obsession with vanity is all about is in for a rude awakening as are many other investors who think passive investing and robo-advisers are the key to long-term investment success.
There's no doubt that ETFs are driving the market higher, along with central banks expanding their balance sheets to a collective $15 trillion and companies emitting bonds to buy back shares like there's no tomorrow, artificially manipulating earnings per share, ensuring their senior managers get compensated very well. This is all part of profits without honor.
The problem with passive investing -- and this is what I want all of you to take away -- is just like anything else, the more money that goes in there, the worse the prospective returns.
In other words, the growing popularity of passive investing will ensure its future demise. The same thing with other investments, including hedge funds and private equity. As institutional investors shove trillions in these strategies, they will only ensure lower future returns.
The great American economist, Paul Samuelson, once touted passive investing but also warned that when it becomes very popular and everyone is doing it, it will spell its demise.
Even Jack Bogle acknowledged recently that this circle of passive investing could turn vicious eventually and cause downright tragic events in the stock market:
“If everybody indexed, the only word you could use is chaos, catastrophe,” Bogle told Yahoo Finance at the Berkshire Hathaway annual meeting last month (in May). “The markets would fail,” he added.Mr. Bogle isn't stupid, far from it. He understands the pros and cons of passive investing better than anyone else and why passive investing requires active investors as there is a mutual symbiosis. He also realizes that past a certain threshold, passive investing will run into big trouble, and when the beta bubble bursts, it will spell big trouble for passive AND active investors.
Bogle noted that trading would dry up if the stock market comprised only indexers and there were no active investors setting prices on individual issues. Everyone would just buy or sell the market.
Bogle has also warned that smart beta may be over-promising and that the stock market will return 4% annually, which won't be enough to help many chronically underfunded US public and private plans.
I personally believe we are close to a rude passive investing awakening which is why in my last comment looking at what top funds bought and sold during the second quarter, i unequivocally recommended investors reduce their stock market exposure and increase their holdings to boring old US long bonds (TLT) and pay NO fees:
I'm willing to bet anyone reading this comment that over the next year, US long bonds will significantly outperform hedge funds on a risk-adjusted basis.All this to say while I agree with Hiromichi Mizuno, chief investment officer of Japan’s $1.4 trillion Government Pension Investment Fund, that market efficiency will be damaged by the rise of passive funds, I also believe when the giant beta bubble bursts, it will roil passive and active investors alike and only US long bonds (TLT) will act as the ultimate diversifier.
"Yeah but that's not sexy. Hedge funds and other alternative investments offer higher returns than bonds over a long period and we get to travel to New York, London, and other cool places to meet these managers who wine and dine us at nice restaurants and take good care of us, making us feel very important."
I hear you, my dear pension fund managers, been there, done that. All I can say is what the late great George Carlin repeated many times: "It's all bullshit and it's bad for you."
"Leo, is that your hyperthyroid talking or is that really you?". I assure you it's really me, I'm treating my hyperthyroid with two little Tapazole pills every morning and should be fine in one month (the endocrinologist told me I have Grave's disease and likely had it for a long time, but it's treatable).
Folks, I know, bonds aren't sexy. The Maestro and others think there's a bubble in bonds, but they don't understand the inflation deflation mystery. They think Trump will save us with tax cuts and big spending on infrastructure, and rates will rise to new highs. Keep dreaming, I warned you a long time ago, nobody trumps the bond market, especially not Trump.
In fact, I'm on record stating the 10-year Treasury note yield is headed below 1% and might touch 0.5% or head even lower if a global deflationary crisis develops.
When that happens, you won't care what Tepper and Soros bought or sold in the stock market. Soros will come out ahead of the hedge fund pack once again, not based on his stock selection skills, but on his great bearish macro calls.
And as I've stated many times, what really worries me isnt when the tech bubble bursts, it's when will deflation come to America, and clobber all risk assets across public and private markets for decades to come.
Now, I realize GPIF is a pension whale and just like CPPIB and other large pension funds, it can't just sell everything and hide in US Treasurys the way I have done recently. I want no part in this market and it's not because I can't invest, trade, and take intelligent risks, I just think it's not worth the energy and stress and truly feel US long bonds (TLT) offer the best risk-adjusted returns going forward.
Right now, I prefer to sit back and let the market come to me, not chase opportunities that might or might not pan out in individual stocks.
Japan's GPIF and CPPIB ar long-term investors and they need to think more carefully about how they will construct their respective portfolios across public and private markets to ride through the coming pension storm.
In this regard, CPPIB is well ahead of GPIF but it's a lot smaller too. GPIF will have a very hard time finding solid active managers across public and private markets as the mystery of inflation-deflation unfolds.
Still, GPIF is moving as fast as possible to diversify into private markets. It recently announced it's plowing into real estate, asking asset managers around the world to submit proposals to run portions of the fund's real estate investment portfolio.
But make no mistake, GPIF's assets recently it a record¥144.9tn on the back on passive investments and the fund has massive beta exposure, far more than its large peers around the world. This is why the focus right now is on active managers in public and private markets.
Hope you enjoyed this comment. Once again, these are my views and I don't claim to have a monopoly on pensions and investments. My number one job is to make you THINK outside the proverbial box. I thank all of you who support my blog and to those of you who haven't, please donate and/ or subscribe via PayPal on the top right-hand side (view web version on your cell phone).
Below, as ETFs blow past hedge funds, hedge-fund billionaire Paul Singer has had enough, stating the move to passive investing is "destructive to the growth-creating and consensus-building prospects of free market capitalism."
If you ask me, hedge funds have been destroying capitalism for quite some time so it's nice to see them get a taste of their own medicine. Of course, Singer raises excellent points, but I'm tired of hedge fund billionaires who amassed a fortune by squeezing public pensions funds on fees telling us what's wrong with capitalism.
What's wrong is the rise of inequality to a point where the wealthy have effectively hijacked the US political and economic system and the public responds by voting a demagogue like Trump into office.
I highly recommend all these hedge fund billionaires read Michael Walzer's classic book, Spheres of Justice, which remains one of the best books I've ever read on distributive justice and pluralism.