July 1, 2020 – One question that I frequently get – in the comments section, via email and in-person – is whether the continued shift away from active stock picking and into passive index investing is all going to create one big, scary bubble. Will this all end in tears? As a member of the FIRE community and a lifelong true believer in passive indexing, it definitely piqued my interest when I heard that I’m (partially) responsible for increasing market inefficiencies and dislocations and potentially even a bubble.
The issue of the “passive investing bubble” bubbles up, so to say, with great regularity. An example is the August 2019 Bloomberg piece “The Big Short’s Michael Burry Sees a Bubble in Passive Investing” likening the current state of the equity market to the crazy CDO market right before the 2008/9 meltdown. Well, that definitely got everyone’s attention! Especially during the slow months in the summer when there isn’t much else going on and financial journalists have to come up with some eye-catching headline!
Long story short, I find that this a bunch of mumbo-jumbo. And instead of replying via email about 10 times a year I just decided to write a blog post about this topic, so I can point to this post in the future if there are people still wondering about my views. That saves me a lot of time and I get to distribute my view to a larger audience, just in case other readers had this same question. And I get into the details a bit more than in a short email reply.
So, why am I not too worried about this shift to passive indexing? Let’s take a look…
The word “bubble” is overused
“‘The Big Short’s’ Michael Burry Compares Index Funds to Subprime Bubble” Source: Yahoo! Finance
First, when I hear the word “bubble” referenced in the popular media my BS radar is flashing red. Everything is called a bubble these days. The only certifiable bubble I can think of is the number of times financial journalists and so-called experts use the word bubble to characterize even the slightest misvaluations or trends:
- Small-cap stocks underperformed for while? Then large-cap stocks must be in a bubble. Never mind that small-cap stocks outperformed for decades before the trend reversed!
- Value stocks underperformed for a while? Then Growth stocks must be in a bubble. And again, never mind the fact that value stocks outperformed growth stocks for decades before then! (also see my post on small-cap and value stocks from last year)
- The stock market is holding up remarkably well, even with all the craziness and uncertainty that 2020 brought? Must be a bubble!
- … and so on!
With that general caveat in mind, let’s look at some of the specific reasons why I’m a lot less worried about a “bubble”…
Don’t confuse micro and macro
The way I interpret Michael Burry’s statements is that he doesn’t necessarily argue that the entire market is in a bubble. Segments of the market are overvalued while others are undervalued. Hence, his own long equity holdings in small-cap stocks. By the way, that’s very different from the CDO market where everything was overvalued due to fraud. So, the comparisons between the alleged passive bubble and the mortgage/MBS/CDO bubble already look a bit spurious and contrived. I’m not sure if Burry truly believes this himself or if he was just egged on by the journalist who wanted a lurid headline.
In any case, with only passive investors around, any potential misvaluations (cross-sectionally, i.e., stock vs. stock) cannot be ironed out because passive, cap-weighted index funds spread new inflows into the market exactly according to the index weights without any regard for what stocks are over or undervalued. In contrast, active managers pick and choose a few dozen names they find attractive after spending a lot of research identifying those undervalued stocks. So, one can indeed make the case that if investors are getting lazy and they are shifting more and more money into blind, passive index investing then they will hamper the “price discovery mechanism” of individual stocks. In the words of Yahoo! Finance…
“[…] passive investing has removed price discovery from the equity markets. The simple theses and the models that get people into sectors, factors, indexes, or ETFs and mutual funds mimicking those strategies — these do not require the security-level analysis that is required for true price discovery. Source: Yahoo! Finance
But even if that’s true it doesn’t imply that the entire market will be in a bubble. If you buy a total market index then you will automatically hold all of the overvalued and all of the undervalued stocks. In the end, everything just averages out. The irony is that if the Burrys and Bloombergs and the (literal and figurative) Yahoos of the world are correct and passive indexing indeed creates cross-sectional misvaluations in the stock market, then that’s an additional rationale(!!!) for me to do passive indexing. I’d be afraid that if I held individual stocks that I’m stuck with all the losers!
In other words, too much passive investing may create misvaluations within the stock market, not necessarily a misvaluation of the market overall, e.g., relative to other asset classes like bonds or real estate. For example, Burry still owns stocks and believes that small-cap value stocks that he considers are a good deal.
Herb Stein’s Law
Let’s now assume that passive investing indeed hampers (to a degree) the price finding mechanism of individual stocks. Where will that all end if we keep up the current trend? Every time I read a story about someone predicting doom and gloom through extrapolation of a current trend I look at it through the lens of Herb Stein’s Law, which posits that…
“If something cannot go on forever, it will stop.”
“Trends that can’t continue, won’t.”
To drive home his point, let me construct this following thought experiment: If I were to reduce my food consumption by 200 calories per day, I’d lose about 1 pound every 18 days. That means I’d be completely gone, reduced to a weight of exactly 0 pounds and 0 ounces in under 10 years. Going beyond 10 years I’d then have a negative weight. I better tell my wife to watch my food intake, so I don’t float up into the stratosphere before our 20th wedding anniversary. OK, just kidding. This example shows how childish it is to (linearly) extrapolate a trend without considering some natural adjustments, price changes and behavioral changes. In economics, we call those “general equilibrium effects” (as opposed to partial equilibrium). Most likely, after losing 10 pounds, my required calorie intake is probably down by about 200 calories and the weight loss would stop.
Same with passive investing. Eventually, the mispricings across different stocks would be large enough to make active investing attractive again. If every investor on the planet were to go passive, I’d certainly dust off my old accounting books and I will do the security analysis and start making a killing in the market! Problem solved.
A more academic explanation: Grossman & Stiglitz
I view active and passive investors as living in a symbiotic relationship. For the economics wonks (I’m one of them, University of Minnesota Ph.D. in 2000), there is a beautiful, classic paper written by Sanford Grossman and Joseph Stiglitz and published in “The American Economic Review” in 1980 (free pdf download here) that formalizes this “symbiotic” relationship between active and passive investors. And for people who’re too lazy to read the whole paper, the punchline is already in title:
“On the Impossibility of Informationally Efficient Markets”
In other words, to use the language of Burry, Bloomberg and Yahoo! Finance:
The “price discovery mechanism” of financial markets can never be 100% efficient and transparent
The intuition behind this result is that an information inefficiency or imperfection or asymmetry – whatever you want to call it – has to persist. If passive investors could just free-ride on the “price discovery” services of the active investors and gather the exact same information that way, why would anyone want to become an active investor and spend the time and effort and money to research companies and study reams of accounting data?
It’s like the free version vs. the for-pay version of some newspapers online. If you want to get all the articles you have to pay. The free version has less information. There has to be an “information gap” between the free and the for-pay versions to entice people to pay for the subscription!
I also like to push back against the notion that passive investors are “abusing” or “free-riding” or “leeching” on the hard work of active investors.
Rather, it’s a symbiotic relationship!
Active investors benefit greatly from having passive investors around, too. Imagine you were an active investor in a perfectly informationally efficient market. You do your research and you notice that stock XYZ is undervalued. The millisecond you put in your buy order the price jumps to its fair value and – POOF – most or even all of your buying opportunity is gone. But with a lot of passive investors around and informationally inefficient markets, an active investor can sneak in his/her buy orders between all the “uninformed” buy and sell orders and not immediately reveal to the world that he/she has developed a buy signal. So, in that sense, active investors are very much leeching on passive investors, too. The latter muddy the water, so the former can more efficiently utilize their equity research alpha!
Summary so far:
- There will always be information asymmetries in the market!
- I’m not worried about cross-sectional misvaluations in the stock market!
But should I still worry about an overall misvaluation of the stock market due to indexing? If most of the active investors and stock pickers were to go away, will that create a bubble? Well, that brings me to the next point…
Active investors and stock pickers are terrible(!!!) at spotting (macro) bubbles
First, let me point out another obvious fact: we’ve seen bubbles for as long as financial markets have been around. All before Bill Fouse invented the equity index fund in the 1970s!
Footnote: No it’s not Jack Bogle! Bill Fouse, then at Wells Fargo, introduced the first institutional stock index fund in the early 1970s. Jack Bogle introduced the index fund to retail investors several years behind Mr. Fouse’s pioneer work. Mr. Fouse went on to start Mellon Capital Management (initially a subsidiary of Mellon Bank and eventually Bank of New York Mellon), the company where I worked from 2008 until 2018. Though Bill Fouse was already retired when I started, he was still around as the chairman emeritus and was revered by everyone in the firm. Sadly, he passed away last year, see the WSJ obituary. He was a true finance superstar and visionary. Despite his fame, he stayed very kind and humble all his life.
Active investors on a frenzy have been involved in every single speculative bubble since the Dutch Tulip Mania! The biggest (overall) stock market bubble in recent history built up during the late 1990s and popped in 2000. Was that due to index investors? I doubt it because index investing wasn’t that prevalent in the 1990s. How could there be a bubble with so many smart and active investors out there? You guessed it, the bubble emerged not despite but exactly because of a bunch of active investors jumping on the technology bandwagon and driving up the price of essentially worthless dot-com startup stocks.
So is it possible that stock pickers, while sometimes being good at identifying relative mispricings across stocks, are not very good at pricing the aggregate stock market? You betcha! Let me share some of my own experiences of working in the industry. I used to work in the Global Macro Asset Allocation group from 2008 until my retirement in 2018. As the name suggests, we were not studying individual stocks, but only the broad global asset classes: stocks vs. bonds, different country stock indexes, currencies and commodities. Even though our object of study was the overall stock index (e.g. S&P 500, DAX 30, CAC 40, FTSE 100) we’d certainly look at the earnings forecasts of analysts covering the individual constituents. It’s because we could aggregate them to get a forecast for the index earnings. And again, those individual forecasts come from the “security-level analysts” that the active investing crowd deems so essential for the proper functioning of financial markets.
How good a job do these smart, hard-working and essential finance professionals do in predicting aggregate earnings? To say it diplomatically, they did a very poor job of identifying breakpoints in aggregate earnings. In other words, stock pickers can likely predict the relative earnings trends of Exxon Mobil vs. Chevron vs. ConocoPhillips etc. with some accuracy. But analysts are usually woefully unsuccessful in predicting turning points in aggregate earnings growth, i.e., timing the transitions from earnings expansions to earnings recessions and back.
And the effect of this in the macro asset allocation world? If you were to blindly use the bottom-up aggregated earnings at face-value for a model to allocate, say, between S&P 500 index futures, U.S. 10Y Treasury Futures and Treasury Bills, then you would regularly get hammered around the turning points. The stock market drops, aggregate earnings forecasts are still elevated, so stocks look like a great buy, right? But it’s a trap! Stocks look cheap only because the analysts are too late in walking down their rosy earnings forecasts! You’d regularly raise your equity share way too early during the bear market!
So, one of my first duties at Mellon was to revamp that earnings forecast process with something more robust and responsive around economic turning points. I can’t go into the details, because I don’t want to get sued by my former employer for disclosing proprietary methods. But take my word for it, if you talk to anyone in the industry they will confirm that bottom-up aggregated index earnings are way behind the curve around economic turning points. They should be used with extreme caution in aggregate (across-asset-class) asset allocation models. Stock picker earnings forecasts are not bubble-proof at all! Never trust a macroeconomic forecast from a microeconomist!
If there is a bubble it’s probably not created by passive investors!
Just for the record, equities do seem a bit expensive no matter what measure you look at; PE Ratios (both forward and backward-looking), the Shiller CAPE, Price-to-book ratios, etc. That was true before the 2020 market meltdown but even with a 10% discount relative to the February market high, we’re still looking at a CAPE ratio in the high 20s. That is still very expensive by historical standards. Would I be shocked if the market were to drop by 20%? No! But 1) I wouldn’t call that a bursting bubble and 2) I seriously doubt that it’s because of passive investing. Much of the flows are simply swapping active -> passive. All active investors combined have to comprise the index again (by definition). You’re “robbing Peter to pay Paul” and I don’t quite see how swapping “index for index” can create a bubble. Again, the only “passive indexing bubbles” would be in the relative, not in the aggregate valuation. Invest in your broad index fund and you’re averaging out the cross-sectional misvaluations!
Before people walk away thinking that everything is A-OK with passive investing and there’s nothing to worry about, let me state, just for the record, that there is indeed one little fly in the ointment. When you own stocks outright you get an invitation to annual meetings and you get to vote to approve or disapprove board members and initiatives. If you only indirectly own a share through an ETF you abdicate your voting rights to the ETF provider. This has made the large ETFs providers – Blackrock (iShares), Vanguard, State Street (SPDRs) some of the largest voting blocks of publicly-traded corporations. Gee, a handful of people wielding tremendous power and influence over $20+ trillion worth of U.S. market capitalization – what can possibly go wrong?!
Ideally, we want to have enough passive index fund providers so that there isn’t one single large player that can put its fingers on the scale of such a large part of the economy. Personally, I hope that Fidelity, Schwab, BNY Mellon, etc. will expand their indexing business so we have more competition and less concentration of power over corporate boards. Regulators might have to get involved as well. But it’s not a good reason to impede the growth of passive investing at large! Why throw out the baby with the bathwater? For more on this topic, check out the WSJ, including the issue of governance. It’s in the for-pay version, though! 😉
And, of course, there is also an advantage when investors outsource their governance role to large index fund managers. The professionals could potentially do a better job at keeping the boards of publicly-traded corporations in check than the sometimes clueless und gullible mom-and-pop investors. Ask yourself, for all the individual stocks you own, would you want to attend all the annual meetings? I heard from Carl (Mr. 1500) that the Berkshire-Hathaway meeting is a lot of fun, but would anyone with a diversified stock portfolio (30+ names) want to attend 30+ meetings every year? Would you read all 30+ annual reports? Read all the bios of all the directors up for election? Vote on all the initiatives? Keep up with the news on all your individual stocks? That seems like a full-time job. I’m happy to outsource that!
So, there you have it! I’m a big fan of passive investing. The fears of passive investing creating instability in the financial sector seem really overblown to me!
I hope you enjoyed today’s slightly random but nevertheless important topic. Please leave your comments and suggestions below!
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