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Fighting the trend towards passive investing often feels like Don Quixote’s crusade against windmills. Despite his undeniable virtues, the brave hidalgo was systematically vanquished by the mineral might of his enemies. Similarly, the flood towards passive funds has overwhelmed the admonitions of impoverished active managers.
Yet, I will ignore these prudent warnings and argue that the ETF industry has betrayed the sound principles laid out by J. Bogle 40 years ago. Passive flows are not truly passive: rather than replicating the structure of the market, they tend to favor a handful of high-multiple stocks in the technology and healthcare sectors.
The second part will present the philosophical case against passive investing. Even though it is impossible to prove what the “peak passive tipping point” might be, I will argue that the index fund mania is already causing negative externalities. These side effects include sky-high valuations, artificially low volatility, high inequalities, lack of competition, and lower economic growth.
The last part will offer two suggestions for active investors to survive the passive ice age. First, a core-satellite approach may allow investors to collect the free-rider dividend from passive investing, while simultaneously retaining some of the upside, and pleasure, of truly active stock selection.
Second, the DUMB beta portfolio that I presented last year should eventually benefit from the tendency of “smart beta” ETFs to pile into a handful of similar stocks. The stocks that are not included in popular ETFs will eventually offer a higher equity risk premium, allowing active investors to capitalize on the inefficiencies of the ETF mania.
The ETF World versus the Real World
Before I start my criticism of ETFs, I would like to explain that I completely agree with John Bogle’s case for low-cost index funds at the individual level. Whenever friends ask me to rebalance their 401Ks, I invariably direct them to the most diversified, cheapest, passive funds. The “passive-versus-active” debate is a bit of prisoner’s dilemma, where players’ individual interests are orthogonal to the group’s collective welfare. Cheap passive funds allow individual investors to free-ride on the work of others: value managers, hedge funds, short-sellers and the few fools who still believe that researching markets is a useful exercise that should be compensated – a ludicrous idea, I know.
That being said, the current ETF landscape is quite different from what J. Bogle had in mind when he launched the First Investment Trust 40 years ago. A plethora of exotic niche ETFs has polluted the initial simplicity of indexing, as he explained in a recent Financial Times column. Passive investing works only if the passive investors are truly passive, i.e., if they just replicate the existing structure of the market. If the ETF industry does not reflect the underlying structure of the market, ETFs will misallocate capital and create differences in stocks’ expected returns. Bubbles will form around the stocks that are over-represented in the indices tracked by ETFs.
A quick look at the ten U.S. equity funds that collected the most money this year shows a significant discrepancy from J. Boggle’s principles. Only two funds, Vanguard’s Total Stock Market Index Fund and iShares’ Core S&P Total Market Index fund, are consistent with the goal of passively replicating the structure of the market. All the other funds create some bias, by overweighting a certain sector, style, or size.
We can quantify this bias at the stock level by matching ETF flows with their holdings. By comparing how much money each stock received to its relative float-adjusted market capitalization, we can measure how much extra money was poured into these lucky stocks by the ETF crowd. In the chart below, the blue bar shows the actual stock-level flow from the 10 largest ETFs. The red bars show the theoretical flow these stocks should have received based on their float-adjusted market cap.
The winners are the usual suspects:
- Amazon and Apple benefit from their relatively small float. Because a large share of their stocks is still held by insiders, these stocks are relatively over-weighted by market-cap weighted indices.
- Information technology stocks benefit from the steady inflows into the PowerShares Nasdaq ETF (QQQ).
- Healthcare stocks benefit from the popularity of the Healthcare Select Sector SPDR Fund (XLV).
These 11 stocks have collected 16.2% of flows into U.S. equity ETFs, despite accounting for just 13.9% of the float-adjusted capitalization. The distortion is even more massive based on other metrics: these 11 ETF darlings account for just 7.5% of total revenues, and 4.3% of total employees. Maybe the ETF mania has something to do with the emergence of the “winner take all” society, and sky-high valuations for U.S. large capitalizations in the tech and healthcare sectors? To this we shall now turn.
The Philosophical Debate around the Passive Bubble
Before I start my rant, I must warn my readers that a lot of the literature on the passive-versus-active debate is written by people who have a personal stake in the matter. Active managers believe that money should be managed actively, for the same reason that bureaucrats believe society needs more regulation. Active managers have been crowing about “peak passive” for years, and yet investors are plowing money into passive funds at a record pace. According to AllianceBernstein, passive funds have accumulated a 40% market share in the U.S. and 50% in Switzerland. There are now more indices than there are large cap stocks! Yet, there is no scientific way to identify the “peak passive tipping point”, the moment when capital markets are so overwhelmed by passive money that they stop allocating capital correctly. An active manager will always think that there are too many index funds, but an investor who has suffered nine years of hedge fund underperformance may feel differently.
Since we cannot determine in abstracto that capital markets have reached the “peak passive tipping point”, we should look for signs of the influence of passive investing on the economy. If we approached the “peak passive tipping point”, we would observe the following economic symptoms:
- High valuations:
By definition, passive funds ignore valuations. Bogle-like index funds invest solely on the basis of float-adjusted market cap, so they are valuation-agnostic. However, a large segment of the ETF industry is tilted towards high-valuation stocks: as we showed in the first part, a disproportionate share of U.S. equity flows ends in high-fliers such as Amazon and Microsoft.
- Low volatility:
Since the election of D. Trump, U.S. equity ETFs have taken in $172 billion. It is very hard to have lasting market corrections when $1.1 billion of fresh money is plowed into the index every day. As a result, the longest pullback in the Nasdaq 100 index lasted just three days, from Dec. 28 to Dec. 30, when volumes were seasonally light.
- Massive inequalities / “winner take all” society:
Passive investing supports the incumbents. The largest stocks get the most flows, while the small stocks that are not included in the major indices get nothing. As a result, the largest corporations have easier access to capital. Large caps that are over-owned by ETFs can issue stock to this captive demand, and use the proceeds to build empires or white elephants. Amazon’s purchase of Wholefoods and Apple’s new headquarters seem to fit this pattern.
The rise of passive investing also leads to a pacification of corporate governance (pun intended). Index funds do not fight proxy wars. ETFs do not threaten underperforming boards with hostile takeovers. Index funds do not complain when corporate chieftains extend lavish pay raises to themselves. T. Piketty’s arguments on the secular rise of U.S. inequalities gained so much attention at the same time as investors started to worry about a “passive bubble”. I do not think that this is a coincidence.
- Lack of competition:
As incumbents benefit from cheaper access to capital, it is easier for them to put barriers against the entry of competitors and to lobby to maintain their advantages. The Silicon Valley should be a giant incubator for new companies, a place where start-ups continuously challenge and disrupt incumbents. However, the massive cash hoards amassed by established tech companies has turned this ecosystem on its head: rather than being the next Google, every start-up now dreams of being bought out by Google.
These companies would reply that their dominance is the result of their superior intelligence and the visionary talent of their leaders. More modestly, they may also point to the economies of scale offered by the interaction of big data and artificial intelligence. Maybe they are right: if Amazon does take over all commerce in the world, buying it for 183 times earnings will be the deal of the millennium. I am not smart enough to tell whether this will happen, but I can say that shareholders in the 80s would not have put a price tag of $467 billion for a company that reported GAAP earnings of just $5.5 billion in its 20-year existence as a public company.
- Lower growth:
If the rise of passive investing resulted in lower competition and an inefficient allocation of capital, economic growth and productivity would eventually slow, as currently observed by L. Summer and the “New Normal” school.
What To Do About It?
Ranting against the stupidity of blindly throwing money at the index funds may feel good on a psychological level, but it does not help clients make money. If active managers do not want to die like grumpy luddites, they need to devise a plan to survive the passive ice age. I propose the following two strategies.
- The core/satellite paradigm:
Split your portfolio in a fully passive bucket and a hyper-active bucket. This is the strategy that I have implemented in my personal account: about half of my (small) wealth is invested in the lowest cost index funds. There, I only care about fees, diversification, and coverage. I do not try to tilt this portfolio towards any style, sector, or factor. I avoid the “smart beta” marketing gimmicks like the plague. I act as the perfect free-rider, betting that global economic growth, human ingenuity, and other people’s work will earn a decent return on my passive capital. In addition, it is quite possible that the trend towards passive investing will still grow into a massive bubble, where index funds’ market share would rise to more than 90%: if this were to happen, I want to ride this wave.
On the other side of the ledger, I invest about half of my portfolio in extremely idiosyncratic ideas, preferably in niche sectors that fall under the radar of major indices. I look for quality companies in dejected countries and sectors. Last year, I focused on low-debt junior gold miners and well-capitalized Italian banks. This portion of the portfolio typically incurs a lot of volatility and occasional disasters, but this volatility tends to be idiosyncratic. Last but not least, the “wins” are extremely rewarding at a psychological level – my favorite Italian bank has made me feel very smart lately.
- Buy DUMB!
In November, I introduced the DUMB beta ETF which invests in all the companies that do not qualify for inclusion in the “smart beta” ETFs. DUMB initially soared after the election of D. Trump, but has lost its gains in recent months. Investors need to be aware that DUMB is a bet on D. Trump (no joke intended). Because DUMB favors cyclical stocks in old-economy sectors, it thrives when the market has confidence in the pro-growth effects of Trump policy – and that confidence has waned in recent months.
Beyond these cyclical effects, DUMB should eventually earn a premium from the “smart beta” mania. As more investors pile into these “smart ETFs”, the return on their invested capital should fall. Conversely, the stocks which are not included in the indices should eventually offer a higher equity risk premium.