Every economic phenomenon has its day when the investing public turns its back and looks for an alternative way to make a return on one’s capital. Whether it’s hedge funds, real estate, or Exchange Traded Funds (ETFs), the popularity of these investment instruments wax and wane in accordance of where money has been made compared to where money will be made.
Take for example, passive investing, an investment strategy whereby an investor can simply buy a basic S&P 500 index fund, sit back, dollar cost average, and more likely than not come out ahead of someone who actively trades stocks, or buy and sells shares of funds regularly. And this includes highly compensated professional money managers who charge to manage your portfolio.
Passive investing has gotten so popular that in 2009 demand for Bloomberg terminals, which assist traders who actively play the market, decreased by about 20,000 systems as institutional investment companies turned to indexing in search of higher returns.1 Just as recent as last year, demand for Bloomberg terminals saw another decline by as much as 3,000 units; indeed, the passive investing phenomenon is still in full swing, and for good reason. Some market pundits are screaming bubble as capital continues to flow into funds tracking indexes without any end in sight. That may be alarming to some, but we believe that this so-called bubble is different than others in a much more profound way: it is not driven by people seeking excessive returns. The same cannot be said for people who wanted to get rich quick by flipping houses at the peak of the housing bubble, nor can it be said for investors who parted with several hundred thousand dollars to gamble with a hedge fund manager. And it certainly cannot be said for those who speculate in gold, silver, or whatever the metal du jour happens to be.
The reason we think that passive investing is most likely not in a bubble is because the quest to match the market without incurring high costs is not driven by the quest to make millions at the drop of a hat. That, and, historically bubbles have nothing to do with investment techniques and everything to do with asset classes. Value investing, first championed by Benjamin Graham, never experienced bubble-like conditions, even as Warren Buffett was consistently making billions from the strategy. The same cannot be said for the dot-com bubble that occurred from 1995 to 2001.
Burton Malkiel wrote about the history of bubbles in his magnum opus A Random Walk Down Wall Street, where he highlighted financial manias that have inflated (and subsequently deflated) prices of everything from tulips back in the 17th century to houses during the subprime crisis in 2007-08. Each example Malkiel discussed involved an asset class, not a technique of investing. More than anything, investors have learned over the years that they’d be much better off entrusting their money to an index fund than to a professional money manager, an actively managed mutual fund, or a highly compensated financial planner. After all, the more fees an investor pays up front, the less return they’re guaranteed to have.
The numbers are staggering. Since the financial crisis in 2008, there has been a two trillion dollar swing in cash flow from active into passive funds. In other words, investors are voting with their wallets and pouring trillions into index funds while simultaneously moving trillions out of active funds that promise to beat a particular benchmark index.2 So why the drastic change? The probability of a professional money manager beating an index fund has become so low and so widely published that the investing public has had enough. Take a look at any SPIVA report card, which is regularly published by Dow Jones Indices, to measure the success of these professionals. The latest report is particularly damaging to active management because it’s difficult to defend a strategy that loses 92% of the time. And that’s the best result over the 15-year period ending December 31, 2016. When compared against mid- and small-cap funds (as opposed to large-cap), active has lost to passive 95% and 93% of the time, respectively. Time periods are not cherry picked either. Compare the two investing styles against any period, from one year to 20 years, and the outcome is not too far off. It’s unlikely that a bubble will ensue from a winning strategy.
Passive investing is not likely to experience a bubble precisely because there will always be investors who believe that they can beat the return the market offers, whether it’s on their own, or with the help of an investment advisor or fund manager. The ego of those in the business is much too strong to yield to a computer that tracks an index. Moreover, the capital markets would be much worse off if active investing fell by the wayside. Active investing must remain as part of an overall strategy for both individuals and the market as a whole. If it ceases to exist, there would be no one concerned with how companies conducted business, nor would there be value investors who determine the intrinsic value of a company and then buy or sell based on their analysis, consequently forcing management to either improve operations or dissolve and start anew.
Active investing is a necessity, it just isn’t a prudent strategy to invest the majority of one’s savings, especially if their risk tolerance is low.
One area where there tends to be an opportunity to make a return in excess of what an index fund might deliver is with emerging markets. The benchmark index that tracks some of these international funds is called the S&P/IFCI Composite. Over the one-year period ending June 30, 2016, this index actually lost to the average emerging market active fund 58% of the time.3 The winning streak ends as the time period extends to three-, five-, and ten-year periods, but there could be some opportunity to exploit the inefficiencies of such a market. Opportunities are there to earn outsized returns, especially when it comes to viable investment strategies that will undoubtedly persist over trendy asset class bubbles.