Is Passive Investing Creating a Market Bubble?

MW-DF380_bubble_ZG_20150211161118There has been some talk in the media recently about a potential investment bubble  being created by passive investing, for example this article from the Irish Times. As a ‘Passive Investment Firm’ we do regular research on this whole area and felt it would be useful to offer our thoughts on a topic that is getting more and more coverage.

Before we get to the argument, and our thoughts, let’s look at what a Passive investor is and how they differ from an Active investor.

Passive Vs Active 

Whether you believe in Passive or Active investing boils down to your understanding of ‘Efficiency of Markets’. Most of us who work in business, or have an interest in the area, are bombarded with share prices on a regular basis. For many people the recent AIB ‘valuation’ was a good exposure to the concept. A share price is determined on the basis of a number of Key Performance Indicators for a business (go back to Leaving Certificate Business subjects here!) like Price/Earnings Ratio, Dividend Yield and the likes, but also on the simple Supply & Demand economics of a market place. At its core, as with many things in life, the price of a share is what someone is willing to pay for it.

The passive investor believes that, for the overwhelming majority of shares in a market, the price is correct. That doesn’t mean it’s fair or right of course, and the semantic difference can be confusing sometimes. By being ‘correct’, it is simply the price that you could reasonably expect to buy or sell a share for. These prices are arrived at on the basis of thousands and millions of interactions between buyers and sellers, so volume (or consensus) is seen as an important determining factor.

The active investor believes that you should instead look for the right price for a share, and that often they are not. They dispute the wisdom of the crowd and think that they alone have the ability to see where a price will likely move in future when everyone else finally catches up with their view. They use detailed analysis of companies themselves, plus general markets to come to what they believe the right price should be.

Our View

Our problem with an Active approach to investing boils down to just one word… Ego. Essentially an individual or group of individuals take a view that everyone else is wrong when it comes to determining what the right price of a share should be. How they come to this view is often rationalised by plenty of data, but at the end of the day it is an opinion.

Interestingly, the correct price of a share actually incorporates all these active managers views. If some are selling because they think a company is overvalued, or buying because they think there’s growth potential, they are contributing to the marketplace with their actions and the price moves accordingly. Assuming they have no insider knowledge (which is illegal), their views are both meaningless and yet vitally important. Differing opinions on the fair/right price of a share is what makes markets move in the first place!

A New Approach

Historically, active investing was the only real way to invest. Because it was not technologically feasible to buy an entire market, you were stuck to choosing individual of baskets of stocks within it. However, starting in the 1950’s, products known as ‘Indexes’ (or ‘Indices’, depending on where you come from) were launched to allow the investor buy the whole market. For decades, a small number of people started buying indexes, while the remainder continued to take an active approach, using the index simply as a benchmark to compare performance. However when academics started looking at investor performance overall, they noticed that in most cases the active investors couldn’t beat the index they were benchmarked against over time. This discovery led to the proliferation of passive investing and brings us to where we are today.

The Passive Bubble

In recent years, technological developments have allowed far more investors to come to the marketplace. With easy access to data, many more have noticed the under performance of active investment against passive or index tracking. As expected, this has resulted in a huge outflow of money from actively managed funds into indexes and passive funds. What we are seeing now are concerns, overwhelmingly (and this won’t surprise anyone) from active managers themselves, that passive investing is creating a bubble in market prices. Their view is that passive investing lets companies off the hook in many cases, not putting pressure on them to explain their fundamentals, which is what active managers are meant to do. Basically they worry that we’re all asleep at the wheel and we’re being driven over a cliff…

As part of our research we looked to academia first, as this is where we would expect to find independent analysis. One of the most comprehensive academic papers on this topic that we could find was written by Fama and French (Nobel winners in economics) , which is highly technical but very interesting.  For those that are so inclined you can find it along with a short abstract on their page https://famafrench.dimensional.com/questions-answers/qa-what-if-everybody-indexed.aspx .

For those not inclined to read a detailed paper on this topic, we’ve summarised the key points below,  as well as including some charts. The paper itself was written in 2007, so this debate whether the shift from active to passive has implications for the efficiency of price, i.e. markets functioning normally, is not a new view!

  • The first thing to state is that assets invested in active strategies still massively outweigh those invested passively. From a practical perspective, if the argument that everyone adopting a passive investment strategy would impact market efficiency held – and that is not to say that it does – there is still a long way to go. The below chart was put together last year and shows Total Net Assets (USD) of US-Domiciled, Open-End & Exchange Traded Equity.

Active v passive

  • What’s important to note is that although investors may be holding an index fund or a passive ETF it does not mean that they are necessarily deviating away from a more active asset allocation portfolio and implementing a view on a specific part of the market. They could, for example, be switching between value and growth index funds or indeed between equity and fixed income. This may be based on what they believe is more in favour or based on changes in expected cash flows or expected returns across asset classes. In all cases prices would still be a reflection of the varying expectations of market participants.
  • The pool of market participants can extend beyond investors buying shares in different companies to the actual companies themselves, e.g. events like share repurchases, mergers and acquisition can all impact on price.
  • Whilst there has been an increase in assets in to index funds, the evidence still suggests that the market has been difficult to outguess. The below chart is from the US Mutual Fund Landscape 2017 report and highlights that for the five, 10 and 15 year periods ending December 31, 2016, only 29%, 21% & 17%  of Equity Funds beat their respective benchmarks. The same relationship holds true for Fixed Income.Mutual Funds
  • Finally, many articles make the point that active managers play a key role in promoting good corporate governance and that shifting to passive removes this oversight. This is difficult to prove as strong governance that supports best interest for shareholders can occur regardless of investment philosophy/ strategy. Dimensional for example, devote considerable effort to reviewing proxies and voting in favour of fair treatment of shareholders.

My overall view on this topic is that it is one to watch, but only with detailed analysis and data-driven research. When I read articles like the one referenced in the Irish Times at the start of this piece, I immediately think of one headline that would better encapsulate the whole debate: ‘Turkeys warn of the Dangers of Christmas…’! 

We love talking to our clients and other interested parties about this stuff. If you have some thoughts or comments yourself feel free to get in touch – we’d love to hear from you.

Curran Financial Services are an independent, fee-based, wealth management firm with expertise in portfolio creation and long term investment strategies.

Contact us on 091 861001 or info@curranfs.ie. 

 

Pin It on Pinterest

Share This

Share this post with your friends!