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.”
Or alternatively,
“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!
Corporate Governance
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!
Conclusion
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!
Picture credit: Pixabay.com
That’s a really interesting paper / quote (The “price discovery mechanism” of financial markets can never be 100% efficient and transparent).
From time to time I consider the business model of retail arbitrage that’s used by many of the professional eBay and Amazon marketplace sellers and wonder whether such an approach is sustainable long term.
The paper suggests that there is indeed the ability to continue such a model indefinitely. Unlike the exchanges where there’s a single source of truth for the price of a liquid security, there’s not a single source of truth for common consumer goods and services prices. One must check Walmart, eBay, Amazon, Target, Google Shopping, etc. to find the best price. Therefore, how much more opportunity is there for inefficiencies to exist for the retail arbitrage model.
Who would have thought such a concept would be learnt / affirmed by casually reading a blog post about purported bubbles. Thanks for sharing your thoughts!
Well, the information asymmetry is a little bit different in financial markets, but the idea is the same as in your nice example. You can just buy everything at one location (higher price, no effort) or comparison-shop (lower price but more effort). There’s a trade-off. Similar mechanism with financial assets. 🙂
Amazingly well written 🙂
I reached similar conclusions, in a more confused way though.
My greatest fear is – like you said – issuing too much power to Vanguard and Blackrock in terms of control of public companies.
This should also be added in any ETF 101 (maybe including mine): yeah, ETFs are good because of diversification, cost efficiency, blah blah blah BUT with stocks you have voting rights, with ETFs is your fund provider(s) who express your vote(s).
Thanks!
Yeah good point. Even though, I have the impression that the average FIRE enthusiast couldn’t care less about the voting etc. 🙂
Hi ERN,
another great article! Michael Burry’s greatest interest is to discourage all people from passive investing. Why? Because he is fund manager and those people could be possibly his clients 🙂
Hah, that’s one motive of Burry. The other was to probably “pump and dump” the four stocks that he mentions in the interview. 🙂
Just because people are using more index funds/etfs doesn’t mean they are all passively investing. Many active investors and even some fund managers use index etfs to speculate which has a similar market effect to stock picking for better or worse.
If nearly everyone took a truly passive approach, the stock market would just be a reflection of people’s income/retirement spending. If workers steadily saved 10-20% of their income and retirees withdrew ~4% of their wealth/year passively in index funds, we wouldn’t see nearly the bubbles/crashes or volatility that we see today, just steady increases/declines.
That’s a good point, too. ETFs have now ventured into such more than passive and broad indexes. You can get ETFs for sub-indexes (e.g., small-cap, value, small-cap-value, etc.) and also some “smart beta” styles, i.e., dividend-weighted, low-vol, etc.
Really curious on your thoughts on investing further into more specific ETFs? Personally, I’m of the thought that large caps will rule for quite some time while companies like Amazon and Google rule the world. I’m having trouble rationalizing continuing to invest in large cap/FAANG after they’ve been on such a run, but I also have a hard time believing it will end anytime soon.
If it’s any consolation, the market is usually right. Maybe it’s pricing in the next big boost in productivity thanks to AI and all the US tech stocks will rally even more.
But I’m also worried about the new tech looking really bubbly now.
You make several excellent arguments and what you say makes perfect sense. I had not really thought about the self limiting aspects of the shift to passive investing. I am always leary of having all my eggs in one basket, particularly when the markets are priced at historically high levels so I only keep about half of my investments in stocks. And of those about half are in index funds and about half in individual stocks picked by Personal Capital. Their equity portfolios are about as different from total stock market indexes as you can possibly get and I think gives me some diversity without a huge downside risk. Basically since I have more than I need my goal is just to not lose very much. Maximizing my return is a secondary or tertiary objective. Great post, nobody explains complex ideas in a more readable manner than you!
Oh, wow, I didn’t know that Personal Capital does the stock picking for you. What’s the fee for their service?
We should plan for the future, but we can’t predict the future. When our “plan” becomes a “prediction” we’ve become a gambler and not an investor.
Disagree with that. Forecasting is actually the opposite of gambling. I’d even say that not forecasting is closer to gambling than if you do forecast.
There really nothing simpler than low fee, index investing. It’s easy and safe. I highly recommend reading “A Random Walk Down Wall Street” (Malkiel) and “The Little Book of Common Sense Investing” (Bogle). Both are available on Audible.Com if you like listening to books, too. I’m sure ERN has read both of these books.
Yup! Good reads. Very highly recommended. 🙂
In one of his last interviews Bogle feared that index funds were gaining so much control over corporate boards that there could be a backlash.
“Bogle, who founded The Vanguard Group in 1974, wrote Thursday in The Wall Street Journal that if current trends continue, index funds will soon own half of all U.S. stocks. He thinks that could lead to a dangerous vacuum in corporate governance – with nobody to effectively police the corporate executives who run America’s largest companies.
“Public policy cannot ignore this growing dominance, and consider its impact on the financial markets, corporate governance, and regulation,” he wrote. “These will be major issues in the coming era.””
https://money.com/jack-bogle-index-funds-problem/
Not sure how Bogle could write last Thursday, since he passed away over 17 months ago. So I will assume the WSJ journalist wrote this past Thursday references of prior Bogle views.
I think the interview was from 2018
Yeah, it’s good to know that Bogle had this on his mind already. Again, it’s an issue that can easily be addressed by enticing more market participants (Schwab, Fidelity, BNYM, etc.)
That would be best for the consumer and also for corporate governance! 🙂
Karsten,
Once again you demonstrated and shared your knowledge and debunked the myth of “Passive Investing Bubble” in a succinct manner. I look forward to your next post and have a Happy 4th of July weekend.
Semper FI,
Luis
Thanks, Luis! Happy Independence Day to you, too! 🙂
I’m just commenting so I can subscribe to this post.
Great stuff as usual Karsten.
Yes, we need function to subscribe to comments without posting!
There’s a leading plugin called “Subscribe to Comments Reloaded” that has that feature.
A bit of reconciling may be needed if the current comment subscription and notification solution is Jetpack.
Also, since the above solution transitions comment subscription and comment notification services “in house,” BigERN may also need a solution such as Mailgun to ensure delivery of comment email notifications generated by said plugin. Sometimes the web hosting company doesn’t have accurately-configured (or non-blacklisted) MX records.
Source: 12 years of IT infrastructure/operations experience + tackling this transition on my own blog
Sounds really complicated. I will look for the plugin, though. If it’s something I can implement easily I will do so! 🙂
Yes, but I’m not sure how to implement that in WordPress.
Great idea! 🙂
I can’t believe you are advocating crash dieting, but I suppose I will give it a try ; )
Well written – thanks for sharing using words and explanations I can understand. I have thought about this but never really researched it too much.
Max
Haha, please ignore my dietary recommendations! I’m not qualified to say anything intelligent on that!
Thanks! 🙂
Great post. I am a lifelong passive investor and I am not too worried about passive investors causing misvaluations. I also don’t count calories. I think counting calories to ensure I get the “correct” amount of sustenance is akin to counting breaths to ensure I get enough oxygen. I wonder how all the poor creatures who can’t count and don’t know what a calorie is manage to survive!
Yeah, great point. If it feels right it will be right. You don’t need to know math to get your calorie intake right!
Bubbles are always the result of dumb money, irrationally herding too much into one direction. This is usually caused by a new information, which the market is gradually adapting to through under- and overreactions, as explained best by the current Adaptive Market Hypothesis (AMH or EMH 2.0). And I assume the market is now in the middle of this slow process to adapt to the unintuitive passive investing approach, taking decades. But I think it is indeed in the last boom phase before bursting.
Today, one of the obviously largest continuous capital streams is into passive instruments. Only a small part of this originates from active instruments or regular savings, based on rational decisions with sufficient understanding and thus truly passive long-term orientation.
However, most of that stream is simply irrational performance chasing, following the herd from underperforming active investments, from saving accounts with unacceptable low interest rates and from leveraged betting with cheap money. This gigantic stream is certainl not the ultimate victory of rationality over innate irrationality.
For me that is the obvious formation of a new bubble, which will surely burst sooner or later as always. Of course, denial of this by all those, being part of a present bubble, is rather typical for its formation and requiered for its bursting, nobody can predict, when it will happen.
Bogle already pointed out that the chances of active investing are increasing again due to this herding to passive investing. With a really long-term orientation over many decades, it should be more rational in a micro-efficient but macro-inefficient market to better diversify A) purely passive allocations to convergent risk taking in seemingly endlessly expanding stock, real estate and bond markets with B) purely active investments to divergent risk taking, harvesting and protecting A) against irrational tail events from bursting bubbles.
In Japan, investments just in A) did not recover since the end of the 1980s. This is expected or rather hoped for as a benign scenario ww in the next market phase.
How to handle this better than severely over-allocating to convergent risk taking through stocks and bonds, only suitable for present good times, maybe ending soon? Artemis Chris Cole investigated this deeply over a century and provides really good ideas for much better diversification with his Dragon Portfolio, allocating stocks, bonds, gold, active long volatility and trend-following, see http://www.artemiscm.com/welcome#home
What do you think about it?
Again: there’s no difference between $100 of active money vs. $100 passive money flowing into the stock market for the OVERALL market. Sure, you could create some pockets of under/over-valuation, but for the overall market it doesn’t matter who invests.
Also, as I stated in the post, from my personal experience, the active mangers ARE THE DUMB MONEY on the aggregate level.
But you bring up a good point: There is a TINA effect (there is no alternative). Money flows into stocks because that’s the last remaining liquid decent return asset. But that’s not a bubble either. Sounds like a fundamental effect.
Really enjoyed this read, ERN. I’m a bit of an index fund bubble aficionado myself (https://bestinterest.blog/index-fund-bubble/).
If you’re interested in a couple more related academic papers, I’d recommend:
This one from the famed Fama/French duo–https://papers.ssrn.com/sol3/papers.cfm?abstract_id=502605
And this lesser known one from Palia and Sokolinski–https://www.law.nyu.edu/sites/default/files/Paper_P%26S_Darius.pdf
Cheers,
Jesse
Thanks for your link to your interesting essay. I also doubt that “hand-picking individual stocks is the way to go” for the long run.
However, believing in and following the comfortable mainstream only – currently of passive only investing – has never been a good idea in investment either. Passive only is thus far too risky and not at all sufficient for the long run.
Markets are certainly micro-efficient due to almost zero costs of information, trading and interest as well as due to seemingly endless QE for more than a decade. All this forced more and more investors to go passive with index funds due to the mentioned TINA effect.
Its inflation is certainly not the only bubble. But, even worse, it is part of a much bigger one. It is the present gigantic bubble economy, causing increasing macro-inefficiency in the trillions of USD, CBs needed in March to maintain it.
This will make it even more painful for the “true believers” in passive only investing, when it will burst one day anyway, condemning it as their biggest mistake. But indexing is and will nevertheless remain a sound investment approach but not the only one.
As already mentioned, Chris Cole from Artemis did some deep thinking, particularly on investing well in bubble economies and after, to enable for the really long run of a century. As a result he provided some excellent food for thought with his “Dragon Portfolio” essay.
Chris recommends 5 different passive AND active asset classes for good and bad times. Of course the old-fashioned active stock picking or value investing are not included but non-correlated trend-following and contrarian long volatility. And he warns well reasoned about most other active investment approaches as more or less part of the short volatility bubble economy, which index funds are also a part of:
https://www.finnotes.org/publications/the-allegory-of-the-hawk-and-serpent
Chris’ essay is no easy reading. But I do recommend reading and understanding it as eye-opener to get prepared well for the unknown long run. The present gigantic bubble will burst sooner or later, including all correlated passive index funds as well as active stock picking and smart beta funds.
Yeah, that document has been recommended multiple times.
Personally, I’m not a big believer in the “big bubble” theory. But it’s an interesting and entertaining read.
Very nice links! Thanks!
Here is some hard proof of the passive investing bubble:
https://mailchi.mp/verdadcap/are-passive-etfs-distorting-prices-in-small-cap-stocks?e=039b9ed941
I disagree: IF this is all true (the authors concede that they “[…] do not, of course, know if this is causal”), it doesn’t prove an OVERALL bubble, but simply that small, exotic portions of the market are in a bubble relative to the bulk of the market. Exactly the point I conceded in my blog post. So, it’s mostly a RELATIVE, bubble, not an absolute bubble of the market as a whole, which is what a lot of illiterate journalists want to conclude from this.
“So, it’s mostly a RELATIVE, bubble, not an absolute bubble of the market as a whole, which is what a lot of illiterate journalists want to conclude from this.”
What else should have caused the extremely high correlations of basically ALL traditional assets during the abrupt decline in March, be they equities, bonds even gold…, than an ABSOLUTE bubble of the market?! With the TINA effect, you already named the deeper cause. But it was only a short test thanks to seemingly limitless QE as the root cause.
The dumb money sees no interest on its savings account but sees rising valuations of almost all assets of the market presumably without end. Thus, more and more of it follows the bandwagon and inflates the WHOLE market more and more…
Besides illiterate journalists also deep thinkers draw the same conclusion, e.g., David Swensen in his understating way “One of the obvious areas of opportunity in an environment of extended valuations is short something.” or Nassim Taleb more directly “If you own stocks without a hedge [right now], it’s not rational.”
As I said in the article, I don’t reject the idea of a bubble. It can come from the TINA investors, the low interest rates, the investors abroad looking for a safe haven, etc.
But it has nothing to do with indexing. Had those same bubbly investment flows gone into actively managed funds, it would have created the same bubble.
How do you know that the same bubbly investment flows would occur without passive instruments in the first place? Until 2008 these flows entered through real estate as well as sub-primes. And until 2000 they entered through the new market and its dot.com companies.
Every bubble so far had and probably needed its hyped innovative instruments, naming the bubble after it. They were all considered somehow superior and blindly followed by the herd as presumably fail safe investment. Accidentally, indexing has this role now together with FANG stocks, leveraging each other. Who can really tell, what would happen in a different setting without indexing?
I really admire the great Bogle for being one of the very few innovators and promoters of indexing, acknowledging this fact. He put all his weight behind warning about it, even hinting about growing chances of active investing against passive.
What is wrong with it? Bubbles are emergent phenomena and can happen to anything if the crowd is up to it. The earlier this is acknowledged the better for all involved in it to position themselves with this understanding better than without.
“How do you know that the same bubbly investment flows would occur without passive instruments in the first place?”
All other bubbles before (e.g. 1929, 2000) came about without equity index funds.
“All other bubbles before (e.g. 1929, 2000) came about without equity index funds.”
…as all bubbles before 2008 came about without sub-primes and before 2000 without dot.com stocks… 😉
I recommend “Adaptive Markets: Financial Evolution at the Speed of Thought” by Andrew Lo with the reasons for that and the current role of index funds in this evolution.
Will take a look. Thanks for the suggestion.
Great Content!
Thanks! 🙂
Enlightening – thanks. Though I admit I free-ride and wonder why more don’t – unless, of course, you’re made of superior grey matter:
“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?”
That said, I agree that there is a symbiotic relationship.
Yeah! And I think there are some folks with enough grey matter that will beat the market by picking stocks. Good for them! I’m happy with my index returns.
“The only certifiable bubble I can think of is the number of times financial journalists and so-called experts use the word bubble” 😀
Thank you for the well-thought article
You bet! 🙂
I am not a fan of Passive Investing, that does not mean I do not invest in ETF’s. PMS that I advise has 33% each of Mutual Funds, Stocks and ETF’s. A concept of Active Management of even passive funds.
Every asset class has a bubble, herd mentality is the one that creates it.
Very good point. Sometimes stock selection, market timing, strategic vs. tactical AA are all mushed together. In my post I was mainly talking about the stock pickers vs. indexers WITHIN that one asset class.
This article shows well, how passive investment is driving the current everything bubble. It is nourished by exponential QE and finally inflating the equity bubble through one-way passive flows like into a black hole:
https://seekingalpha.com/article/4120041-black-hole-how-passive-investing-became-new-qe
“As QE seemed to exaggerate trends in the fixed income markets, so it appears that Passive equity flows are exaggerating stock movements.”
Bubble dynamics at its best, accumulating huge alpha profit potentials for patient active investors.
It doesn’t show anything. Correlation is not causation. You should know that. So, the charts show really nothing. And the rest is just conjecture and conspiracy theory.
But again, don’t get me wrong. I certainly believe that Fed policy assisted the stock market. I just don’t believe that index ETFs have anything to do with the equity rally. Without passive investing we’d have the exact same TINA phenomenon.
https://www.wsj.com/articles/thank-the-fed-for-the-stock-markets-runand-the-plodding-pace-to-come-11607256000?mod=hp_lead_pos10
“Without passive investing we’d have the exact same TINA phenomenon.”
Absolutely. It is always the latest hype(s).
“That said, there is a potentially dark side to indexing. It has made momentum much stronger, because the nature of indexing is you pile on to whatever’s going up.” A. Damodaran
Thus, trend-following may have a come-back.
I’m 100% in agreement with Prof. Damodaran. Thanks for the quote. Here’s a link
https://www.commodityresearchgroup.com/a-conversation-with-nyus-aswath-damodaran/. And check this for the full interview: https://elmfunds.com/aswath-damodaran-interview/
1: Due to Grossman & Stiglitz, we can never get to 100% indexing.
2: Momentum will likely become a bigger factor. Keep in mind that the professor has been misunderstood and misquoted because he refers to within the equity bucket, not for the equity market overall. So, absolutely, indexing will exacerbate misvaluations within equities, exactly what I pointed out. So, one should suspect that, say, a Fama-French-style momentum factor should become more pronounced. But passive investing has no bearing on the overall trend-following performance of the equity market. If you do a 75/25 passive index portfolio with monthly/quarterly rebalancing, you shift out of stocks after they go up, therefore you’re going against momentum. It has nothing to do with the professor’s point.
Really confusing, but once we distinguish between time series and cross-section issues it’s all really clear.
Passive works while all prices are rising, the reverse is also true – Good luck in the end.
A lot of people say that “In a choppy sideways-moving market you need the expertise of the active stock pickers to identify what’s going up.” Hmmm, count me a skeptic on that one. If you have bad luck and the active managers miss the handful of stocks that go up you’ll vastly underperform.