Saturday, April 29, 2017

Passive Investing is Changing Everything, at a Price

By Roy C. Smith

Eight years into a bull market in which the S&P 500 has tripled, investors seem to have given up on active managers, preferring index funds and ETFs instead. Survey after survey have shown that the overwhelming majority of active managers have failed to beat their benchmarks over 1, 3 and 5 year periods. Passive investing now accounts for nearly 40% of all US equity assets-under-management, more than twice the level in 2005. Passive funds together now hold about 13% of the S&P 500, up from 9% in early 2013, and account for about 25% of trading reported on the consolidated tape.

In the last two years, according to Morningstar, over $500 billion of funds were withdrawn from active managers and nearly $1 trillion found its way into passive funds tied to market indices. Hedge funds, too, have suffered as investors have withdrawn funds after years of paying high fees for low returns.

This trend is having a devastating effect on Wall Street sell-side research, the production of which is now well below historical norms. A recent Sanford Bernstein report referred to passive investing as “worse than Marxism.”

The principal explanation for the massive migration into passive funds over the last decade is the difference in fees and expenses charged by active managers, especially mutual funds, as compared to the exceedingly low cost of index funds.  This is a theme first expressed by Jack Bogle, former Vanguard Chairman and passive advocate, thirty years ago, but recent events have accelerated the move to passive investing.

Some observers say this new market dynamic is because of the $12-15 trillion of central bank intervention in fixed income markets in the US, Europe and Japan that have made stock investments of all types relatively more attractive than bonds. This unintended consequence of Quantitative Easing has led to mindless notions of “risk-on,” risk-off” investing that ignores individual company performance. Though these QE programs are being wound down, there is no assurance that they won’t be reinstituted during the next downturn.

QE is thought to have raised correlations of stocks with the market as a whole -- to a level of 70%-90% since 2009 from much lower levels before. Low correlations suggest good opportunities for expensive, research-driven stock pickers, and high correlations suggest any stock will do.  

All this confirms that the 2009-2017 bull market has had a substantial synthetic component to it. Continuous market appreciation during a period of unusually low economic growth and an unusual amount of political uncertainty in the US, Europe, China, Russia and the Middle East is hard to explain. These uncertainties have led many active managers to hold unusually large cash positions, but they would probably have been better off if they had been fully invested. They did not participate in the market upside as fully as index funds with no cash holdings did, widening the performance gap.

A recent Goldman Sachs report points also to a new dilemma faced by corporate directors because of the rise of passive investing. Boards can no longer trust the market to value their corporations appropriately, both absolutely and relative to the performance of its peers. Incentive compensation tied to stock prices may no longer be the best way to reward corporate managers – the compensation provided by the market may be completely out of synch with what directors want. Stock prices may also be sending the wrong valuation messages to potential corporate predators, making companies more vulnerable to takeovers.  How boards should respond to these challenges opens a whole new chapter in corporate governance.

Indeed, the surge in passive investing also tends to diminish the effect of the voting power of institutional investors in corporate governance. Long looked upon as a reasonable defender of basic shareholder interests, institutional investors have been the market’s enforcement arm. Passive investors, however, have little concern for governance issues and tend to outsource their voting decisions to firms like Institutional Shareholder Services, concentrating their power in governance issues to an all-time high.

Wall Street has claimed for years that passive investing is useful and has a place as long as it doesn’t “become the market.” Well, are we there yet?

When QE programs began, concerns about market distortions they would cause were brushed aside as less important that rescuing crisis-ridden economies from high unemployment and low growth. It is hard to see, eight years later, that these programs helped growth very much (yes, it might have been worse) though at least nominal unemployment came down significantly in the US.

Future programs, however, will have to recognize that the many long-term effects of distortion of the equity markets can be a high price to pay for their benefits.



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