07 March 2019
Lazy Investing
Following the investment herd has risks.
By Frank O’Nomics
Many will have had that uncomfortable moment in the pub when someone lays claim to a “killing on the stock market”. Proud boasts of having bought ASOS shares at 9p (next stop £70) leave us too polite to point out that they appear to have arrived at the pub via a bus and not a Lamborghini, and hence there must be other less successful investments they have omitted to mention. Volatile markets offer opportunity – but how many of us can confidently say that we have a good call on markets and a reasonable success rate in stock picking? Those who claim to be investment gurus invariably focus on their great successes, rather than failures, when statistically they are more likely to have failed. There is a growing body of evidence to suggest that trying to beat the market is a mugs game and that putting your money into a low cost fund that tracks an index is the best way to reduce stress and save a lot of money. The growth of this conviction is amply illustrated by the data with indexed funds now accounting for $10trn of assets. Should we all be adopting this approach? While the logic seems compelling there are some strong arguments to suggest that the trend has some worrying connotations, which have caused analysts at one investment manager to argue: “passive investing is worse than Marxism”.
First let’s look at that compelling case for passive investing. The most straightforward argument is that for every investor who beats the return on an index there has to be someone who loses. When looked at on average, returns will be worse than the performance of the market in question due to the fact that managers will charge fees. On top of this simple argument, there is a more complex issue that further stacks the odds against the active investor – “skew”. The problem is that the returns from stock markets are very lopsided, with a relatively small number of stocks responsible for the majority of positive returns. On a random basis the chances of picking those key stocks are small and studies have shown that around 70% of stocks will fare worse than (zero risk) treasury bills. Advocates of active management use this as a justification for investing with those fund managers with a proven track record of picking the winners. However, only 19% of fund managers manage to beat the benchmark against which they are measured and few of those manage to do so consistently – an outperformer one year often becomes an underperformer the next.
These arguments have led legions of investors to reach the conclusion that they can’t beat a market benchmark. The shift into passive ETF funds has become exponential since the financial crisis with the size of the sector leaping fivefold over the last 10 years. Last year the “Sage of Omaha”, Warren Buffet won a bet that a cheap index find that tracked US stocks would beat an elite group of hedge funds over a 10-year period – the return was 126% vs. 36%, and twice the return on hedge and private equity funds combined.
So why then should anyone argue that passive investing was worse than Marxism? In essence the argument runs that Marxists at least tried to allocate resources efficiently, whereas investing with an index can create distortions that increase the fragility of the economic system. When a company drops out of the FTSE100, due to it being valued below some outside the index, the passive investor has to sell it to buy the new entrant, which could create a dangerous downward spiral in the stock. Much worse occurs when money overall starts to leave passive funds. If investors become defensive and withdraw to safer assets, the sales from passive funds could create a bear market and potentially a market crash. This is particularly likely in some less liquid assets, such as those in emerging markets, where there is insufficient liquidity to easily facilitate a mass departure, and it is not impossible to envisage problems in larger markets – 25cts in every $ invested into the 2 largest indexed funds goes into tech stocks and a mass withdrawal could hit them very hard (the dot com crash happened when the passive industry was much more modest in size).
There are two other issues with passive investments. The first is that they cramp competition – the biggest funds can charge the lowest fees and will force out the smaller providers. Just a few very large firms already dominate the industry (Blackrock, Vanguard and State Street have 80% of the market), which has caused some to raise the danger of collusion. The second is a lack of corporate engagement. Active funds have been a strong force in using their voting power to ensure companies improve governance structure and act in the best interests of shareholders – rather than just lining the pockets of senior management. A number of passive funds have started to take a stance on some issues, but the incentive to do so is limited when they will have to hold onto the stocks of miscreants regardless as long as they remain in an index. If these firms did start to use their voting power, even that would be a little worrying given that just 3 firms would have such a strong say in corporate strategy.
The investment industry quite rightly made much of the achievements of Jack Bogle, the creator of the first index fund, on the occassion of his recent death. He regarded index funds as “the greatest invention in the history of finance” and summed up the approach as “don’t look for the needle in the haystack. Just buy the haystack!” As a means for those with a modest sum to invest, passive funds offer a low cost way of achieving a good spread of investments and there is no doubt that they fulfill a very necessary purpose in this respect. However, with index investments now accounting for 30% of the US stock market we do have to be aware of the systemic risks posed.
