The rise of passive investing, or "indexing," has been going on since the first index funds were introduced back in the 1970s. But the bull market that began a decade ago in 2009 has really kicked the indexing trend into overdrive.
As I noted a couple of months ago in Is Active Management Broken?:
When this bull market began in 2009, the split of U.S. equity investments was roughly 75% active, 25% passive. This year, the share of U.S. investments passively invested will top 50% for the first time. There are many new passengers on the indexing train that have never before ridden it through a bear market.
That’s a massive shift in dollars that have left active management in favor of following passive indexes. There are many reasons for this, including legislation changes in 2006 that promoted auto-enrollment in company retirement plans and the establishing of target-date funds (which are built on index funds) as the default option in most such plans. Another huge factor in the rise of indexing has been, ironically, the evolution of the financial advisory model toward wrap fees that incentivize advisors to use low-cost index funds in order to keep total client fees down (without cutting into the advisor’s fee).
Whatever the reasons behind it, the shift from 75% of the stock market’s dollars being actively managed a decade ago to 50% or less being actively managed today is a massive shift. While there are implications at the individual investor level (which we’ll deal with in a moment), an intriguing voice has been making the claim in recent weeks that this volume of indexed investments carries potentially dangerous implications for the market itself.
Hedge fund manager Michael Burry sprang into the public eye as the main character in Michael Lewis’ The Big Short book and movie, which detailed the story of 2008’s Great Financial Crisis. The story focused specifically on how Burry identified early on that there was a huge pricing and liquidity issue with collateralized debt obligations (CDO) — the complicated mortgage securities at the center of the sub-prime debt crisis.
Burry has been in the headlines again in recent weeks, having said in a couple of recent interviews that he believes index funds are the new CDO — the misunderstood ticking time bomb ready to create the next crisis. It’s worth reading his full comments on the dangers presented by index funds, but in a nutshell, his concerns specifically boil down to these two points:
1. Price setting is broken. With so much money being indexed now, the accuracy of the market’s price discovery process has been compromised. Without the deep, security-level analysis that used to be driven by the higher level of active management, true price discovery doesn’t take place. And on top of that, the huge capital flows into indexed products distorts the market’s price-setting function by directing money into (and away from) certain stocks with no respect to valuation or any other "worthiness" type of metrics.
2. Liquidity risk is huge. The actual trading volume of many of the stocks in some of the most popular indexes is tiny relative to the total assets following these indexes. He offers the following examples:
In the Russell 2000 Index...the vast majority of stocks are lower volume, lower value-traded stocks. Today I counted 1,049 stocks that traded less than $5 million in value during the day. That is over half, and almost half of those — 456 stocks — traded less than $1 million during the day. Yet through indexation and passive investing, hundreds of billions are linked to stocks like this. The S&P 500 is no different — the index contains the world’s largest stocks, but still, 266 stocks — over half — traded under $150 million today. That sounds like a lot, but trillions of dollars in assets globally are indexed to these stocks.
The theater keeps getting more crowded, but the exit door is the same as it always was. All this gets worse as you get into even less liquid equity and bond markets globally.
Go sell crazy somewhere else
Not everyone buys Burry’s argument though. Influential investment personality Joshua Brown wrote a rebuttal of Burry’s thesis last week, arguing that "The Real Bubble Has Always Been in Active Management":
The real bubble is in actively managed funds. But we’re nowhere near that bubble’s peak, which was in the mid to late 1990’s. It’s been slowly deflating since the Great Financial Crisis – the moment the Boomer generation truly fell out of love with investing as a pastime or a recreational activity permanently.... From 1987 through 2007, we had a twenty year bubble in investor preference for active managers and stockpicking as a sport and investing as a hobby....
And then it all came crashing down as the millennium rolled over. Whatever enthusiasm the dot com bubble and bust didn’t destroy in 2000-2002, the credit bubble and subsequent Great Financial Crisis would finish off just a few years later. By 2009, the Boomers were ten to fifteen years removed from the heyday of enjoyable active management and they were done with it.
Brown’s argument is basically that for decades prior to the 1980s, almost all investors were passive investors via their involvement in corporate pension plans. Then there was a roughly 20-year aberration when investors got really interested in handling their own investments, which both spurred and was spurred by the rise of investing as a type of entertainment, complete with star fund managers, etc. But since the GFC a decade ago, investors have been returning to their normal stance as passive investors via index funds.
I think both Burry and Brown might be right.
From our vantage point, Brown’s points ring true. SMI was born in the glory days of "do-it-yourself" investing and we’re grateful for every single one of you readers who still makes the effort to be hands-on with your personal investing. We think there are some potentially significant advantages to this type of personal involvement and knowledge! But I wouldn’t for a minute argue the direction of the overall trend away from that type of engagement. Fewer people want to handle investing themselves anymore. For many, investing has become another necessary task that they prefer to outsource. (SMI Private Client is our response to these shifting investor preferences.)
But Brown’s points are specifically about whether individual investors are personally engaging in active management or not. Burry’s point is different — that the way the actual dollars are being invested is changing the market itself. These are different arguments that overlap, but aren’t the same.
Yes, most investors may have been personally passive investors prior to the 1980s. They weren’t personally making active investing decisions, they were delegating those decisions to the pension plan managers of the company they worked for. But here’s the key — those institutional pension plan managers weren’t necessarily passive. Index funds didn’t even exist until the late 1970s, and didn’t become really popular — with anyone — for years after that.
So while individuals were passive, their money was not being managed passively. It was still actively managed money, which contributed to the market’s price discovery process. Brown is right about individual investors as a group being primarily passive for many years, then waking up for a brief period of peak active management, and now seemingly drifting back to being primarily passive again. But the actual investments were never passive to the degree they are today. And that’s the important point to Burry’s argument.
How big an impact?
All of that said, it’s impossible to know how big an impact the rise of passive management will have in the next downturn, simply because the market has never gone through a transition quite like this before. It seems to me that there are two components of the shift to passive/index investing. There’s the "technical" aspect, the impact on the market functionality itself, which is what Burry is focused on. There’s also potentially a "psychological" aspect of a large number of new indexers watching their portfolios drop with no downside protection, which is the angle SMI has largely focused on in the past, as that also seems to hold the potential to make the next bear market faster and/or deeper than it would be otherwise due to these novice indexers panicking.
I’ve seen other long-time investors write things to the effect of "There are no buy-and-hold indexers." I don’t believe that’s true, but I think the sentiment it conveys will be tested in the next bear market. Simply put, it’s really hard for any investor — actively managed or indexed — to sit still and watch their portfolio get ravaged by a bear market. At least with active management, investors have some hope of limiting the damage (think DAA and Upgrading 2.0). But indexers? There’s no hope of limiting the downside. So as those losses mount, the only option to stop the pain is to sell. And that’s where the idea that few indexers actually survive bear markets with their holdings intact comes from.
Burry was correct about CDOs in the last bear market when most investors were either clueless to the risk altogether, or vastly underestimated its potential impact, and he made a fortune based on that accurate analysis. That doesn’t mean he’ll be right about index funds this time, or that the impact will be as dramatic as he thinks. But it’s probably wise to at least consider the impact.
On a personal level, if your portfolio relies primarily on index funds, this might be reason to consider diversifying it somewhat to include the active managed (and more defensively minded) strategies linked to above.
