The passive investment boom
Record inflows to ETFs and Index Funds mask danger
Danger in the current market resides prominently in what feels the safe to most - passive investments in the form of exchange-traded funds (ETFs). The passive funds versus actively managed funds debate has raged on with a general consensus view supporting the school of thought that investors are better off in cheaper passive funds. This viewpoint argues that it is better to hold a large basket of stocks, as there is no value in individual investors picking individual shares. Large amounts of money have followed this view with inflows into US equity ETFs alone reaching a record of US$15 billion per month in the last 5 months. Founder of index fund pioneer Vanguard, Jack Bogle, warned his staff years ago about the dangers of being too large, as his firm’s assets crossed the $8 billion mark. Today, that number stands at $4.2 trillion!
It strikes us as an odd proposition that there can be no advantage in doing the difficult work of understanding what underpins a business and ascertaining a suitable valuation. If you take the passive investing concept to a theoretical extreme, you will be left with a handful of shareholders who actually read the annual report and reach a view on the inherent value of the business. All remaining shareholders will simply follow the lead of this small group. Although they may exercise great effort in other aspects of their lives, investing is deemed too hard, hence no effort made.
Coming back to Vanguard, in the last three calendar years, investors put $823 billion into Vanguard funds. And where does that money go? What process dictates the allocation of so much capital? New money is simply allocated based on float. To pick a bond ETF as an example, the more indebted the company, the more money will be allocated to it by the ETF. No account is taken of the valuation or balance sheet of the issuing company. When Petrobras, possessing already precarious finances, issued more bonds, the ETFs had to buy more. When Vanguard’s traders allocate $2 billion daily into stocks price discovery is not part of the process. As there is no consideration of price, this buying represents artificial demand. By its nature this buying is divorced from underlying business fundamentals.
The ‘don’t try to pick stocks yourself’ view is reaching the point of becoming a crowded bandwagon. It is at the point when the idea is most widely accepted that it becomes most dangerous. By then the concept has a demonstrable history of success and more investors crowd the trade. For a time this will be self-reinforcing, as more money is added to the same stocks, which in turn adds to the momentum of what has worked recently. For the anointed ETF constituent stocks fundamental problems will be papered over - for a time. Examples abound of businesses, such as McDonald's Corporation, whose fundamentals have deteriorated significantly over the time period during which ETFs have risen to prominence. An objective analysis of this business shows that earnings growth has slowed as consumers move to healthier choices and that its valuation should have significantly decreased. And yet, its price has moved higher in lockstep with ETF buying.
After a time, as history has repeatedly shown, the end will be an unhappy one for later arrivals. Add to this mix the prospect of further global interest rate rises and an expensive US stock market (trading on a cyclically adjusted P/E of 28x). The current valuation level has been exceeded only twice in US markets - in 1929 and the dot-com bubble era. Putting it together, you have a recipe for coming trouble exacerbated by the less than entirely rational capital allocation processes of the ETF industry.