Is Passive Investing Taking Over?
Passive investing could eventually account for 90 per cent of the equity market, according to Jack Bogle, founder of Vanguard and pioneer of the index-based investing that has upended the asset management industry.Interestingly, back in May, Jack Bogle was warning index fund investors at the Berkshire Hathaway annual meeting that if everybody indexed, it would be catastrophic:
Passive investment of stocks through mutual or exchange traded funds that simply track an index — and charge investors much smaller fees — accounts for 47 per cent of the assets managed by the US fund industry, posing a severe challenge to active managers who take higher fees with the promise of beating the returns of major indices.
“As a long-term investment strategy, I don’t think the index fund has any competition at all,” Mr Bogle told an audience at the Ivy League clubhouse for Cornell University in Midtown Manhattan this week.
“There must be some limit somewhere with how much indexing there can be without [reducing] the efficiencies of the market,” he said. “[But] if I had to guess, I’d put [the limit] in the area of 70 or 80 or 90 per cent — very large — because there will always . . . be people looking for values, price discovery and all that kind of thing.”
Passive equity management is expected to overtake funds managed by active advisers by January 2018, analysts with Bernstein forecast earlier this year.
However, after lacklustre performance last year, returns have improved for active stock pickers. Nearly 57 per cent of large-cap US equity fund managers beat the S&P 500 over the past year, according to S&P Dow Jones Indices.
Alina Lamy, a senior analyst with Morningstar, said that the battle was “not completely lost” for active managers, but that investors were paying far more attention to fund fees.
“Bogle . . . is the greatest advocate for passive and this is the principle he founded his company on,” she said. “They started it all and they are still ruling it.”
Mr Bogle, who billionaire Warren Buffett credits with doing more for American investors than anyone else, also cautioned that Vanguard is growing too large. Vanguard, whose corporate headquarters are just outside Philadelphia, manages about $4.7tn. It trails only rival BlackRock, which has almost $6tn of assets.
“We’re now closing in on $5tn and I worry about that,” he said. “Running a large company is a very difficult thing . . . It gets harder and harder as you get bigger and bigger. I’ve spent a lot of time trying to rectify that concept.”
The octogenarian added that he was worried about the risk of high concentrations on liquidity and marketability of some of Vanguard’s funds, particularly those in the $3.8tn municipal bond market. Of the $323bn ploughed into taxable bond funds over the past year, 60 per cent was directed to passive funds, according to data provider Morningstar.
There is also a “significant” risk in the form of possible regulation of the industry, although he said he did not believe it was fair to classify the largest fund managers as systemically important financial institutions.
“We run basically an old oligopoly, Vanguard, BlackRock and State Street,” he said. “State Street is the smallest part of that group. An oligopoly is not necessarily bad but it is subject to challenge by regulators, and particularly European regulators . . . It’s hard to predict where that might go.”
Mr Bogle is not involved in the management of Vanguard; he retired from the company’s top post in 1996. A spokesperson for the asset manager said the company’s growth had “been a force for good” in the industry.
“Growth is not a goal for Vanguard but an outcome of delivering clients superior investment performance and quality service at a low cost,” the spokesperson said. “Vanguard has grown responsibly and governed our growth by being prudent in our product development, offering only funds that meet an enduring long-term need.”
The tragedy of the commons is a fanciful term from economics that describes an action whose benefits accrue mainly to the entity committing it and whose costs are diffused. A typical example would involve a manufacturer polluting the air or water, but the expression can also apply to owners of index funds in the commons that are the financial markets.I believe it's as good as it gets for stocks, and with markets on the edge of a cliff, there will be important headwinds impacting passive and active funds (active funds have beta too but should on the whole fare better than passive funds in a bear market).
What makes indexing a tragedy of the commons is that the benefit — higher long-term returns due to lower costs — only accrues as long as there is an active, functioning market underlying whatever index a fund is trying to capture the performance of. While investors and managers of index funds reap the rewards, the expense of maintaining that healthy market is borne by shareholders in actively managed funds and traders who buy and sell individual stocks.
The market cannot exist without those participants engaging in research, analysis and the transactions that result from them, as well as regulation of the market itself and the businesses whose stocks form it. Index fund shareholders largely avoid the costs involved, so the more investors index, the greater the costs for the ones who don’t, increasing the incentives to index.
John Bogle, the founder of the Vanguard Group and the person who ignited the trend toward index investing four decades ago, acknowledged recently that this circle could turn vicious eventually and cause downright tragic events in the stock market.
“If everybody indexed, the only word you could use is chaos, catastrophe,” Bogle told Yahoo Finance at the Berkshire Hathaway annual meeting last month. “The markets would fail,” he added.
Bogle noted that trading would dry up if the stock market comprised only indexers and there were no active investors setting prices on individual issues. Everyone would just buy or sell the market.
The market is not entirely owned by indexers, of course, and it never will be, and Bogle pointed out that as indexing increases to a certain point, it opens opportunities for active investors to exploit inefficiencies in the pricing of some stocks. But past that point, wherever it might be — somewhere beyond 75%, in his view — the market could become a dangerous place.
Bogle did not elaborate in the interview, but as indexing comprised an ever-larger proportion of trading, the limited trading of the few remaining active market participants would cause exaggerated price swings in individual stocks and perhaps the whole market.
Bogle stressed that there is a long way to go before indexing reaches a level at which market stability begins to crumble. About one-quarter of U.S. stock ownership is done through indexing, he told Yahoo. According to investment researcher Morningstar, 46.7% of assets invested in U.S. stocks via exchange-traded funds or mutual funds was indexed in April, compared with 36.3% three years earlier.
One development could mitigate much of the advantage that index funds enjoy and slow the rush to own them, but you’re probably not going to like it. When the market suffers a prolonged decline, active managers can gain an edge over indexers by moving large portions of assets into cash or into defensive sectors such as utilities and consumer staples.
Shareholders of index funds could then suffer more than owners of actively managed funds, and they could take their losses harder due to the perceived security they feel precisely because they merely own the market and aren’t trying to beat it. That might make active investors feel a bit of schadenfreude for indexers who have been free-riding at their expense, but the feeling probably wouldn’t last. The greater price swings that could ensue in a heavily indexed, less-active market are likely to exacerbate losses for everyone.
Until the next bear market, the indexing trend is likely to accelerate. As with any tragedy of the commons, indexing is the sensible thing for each individual to do, but each individual should remember that many sensible ideas, especially in investing, make less sense as more people put them into practice. When the stock market turns down again, index fund owners will have to become their own active manager and make sure they’re well diversified, with limited exposure to risk, chaos, and catastrophe.
Still, there's no question passive will take over active investing in the next two years and Vanguard will be growing by leaps and bounds, likely even taking over BlackRock as the world's largest asset manager.
But don't count BlackRock out just yet from the number one spot. Last week, BlackRock and Blackstone Group announced they are are planning to open offices in Saudi Arabia, encouraged by the investment opportunities offered by the kingdom.
Speaking of Blackstone, its CEO, Steve Schwarzman, told Bloomberg that it may double its assets to $800 billion over the next five years as it looks to cement its leadership in private markets and even get into infrastructure, a very long-term asset class which is highly scalable. In terms of succession planning at Blackstone, my money is on Jon Gray, the firm's real estate superstar investor.
Now, the name of the game at public and private market funds and pretty much all funds is asset gathering. The more assets you bring in, the more fees you collect in perpetuity if you're doing a good job.
Go back to read my comment on the coming renaissance of macro investing where I wrote this:
[...] I don't buy the nonsense of the "end of the petrodollars". This is pure nonsense and all this talk of alternative exchanges that will threaten the preeminence of the US dollar or US exchanges is beyond ridiculous.By the way, over the weekend, I read about how the CIA offered gangsters $150,000 to assassinate Fidel Castro to the horror of Robert Kennedy. The same thing is going on nowadays but it's a lot more sophisticated and more effective.
I suggest Mr. Curran and all of you who buy into this nonsense read Yannis Varoufakis's first book, The Global Minotaur. Let me be clear, I'm no fan of Varoufakis and his pompous leftist nonsense but this book is a must-read to understand why the US is gaining global strength as its national debt mushrooms.
In short, the US runs a current account deficit for years but it benefits from a capital account surplus as all those countries running current account surpluses (China, Germany, Japan, etc) recycle their profits back into the US financial system, buying up stocks, bonds, real estate and other investments as well as subsidizing the US military-industrial complex.
The second book I want you all to read is John Perkins's The New Confessions of an Economic Hitman, an expanded edition of his classic bestseller. You will learn the world doesn't work according to some nice, tidy economic model full of complicated equations. Behind the scenes, there are a lot of dirty things going on.
Importantly, and this is my point, the US dominates global finance and the global economy, which is why I scoff at the idea of China, Russia or any other country is gaining on it and threatens to displace it or displace the greenback as the world's reserve currency.
Anyway, the point I wanted to make is petro profits and all profits made outside the US are recycled right back into Treasuries to fund the growing US debt, the military-industrial complex and Wall Street which loves collecting big fees to manage sovereign wealth fund and pension assets.
And those global investors are increasingly investing in private markets - real estate, private equity, and infrastructure -- where they see the highest annualized returns over the next ten years (click on image):
Nonetheless, as shown above, over the next ten years, no asset class except private equity is expected to return more than 8% annualized, which is bad news for pensions. And most of private equity's returns will come from leverage and asset-stripping.
Maybe that's why some are calling it the twilight for the buyout barbarians while others are defending the industry at all cost.
All I know is that while passive is gaining on active funds in public markets, private markets are gaining on public markets, which is music to Steve Schwarzman's and Howards Marks' ears (fees are much juicier in private markets which are only active investing by nature).
So take everything you read on passive gaining on active funds with a pinch of salt. You need to dig a little deeper to really get a full picture of what's going on out there.
Below, Jack Bogle discusses whether Vanguard's size is a worry. Interestingly, he is cognizant that size can impact performance and sounds more cautious here.
Second, Blackstone's co-founder and CEO Steve Schwarzman told Bloomberg that it may double its assets to $800 billion over the next five years as it looks to cement its leadership in private markets. Blackstone received a commitment of as much as $20 billion for infrastructure deals from the kingdom’s Public Investment Fund.
Third, Howard Marks says stock, bond markets not likely to deliver great returns over next decade, stating "I think that if you look objectively at the market, you see cautionary signs." Marks is talking up his business and industry because if deflation strikes the US, boring old bonds might outperform all asset classes on a risk-adjusted basis over the next decade.
Lastly, BlackRock's CEO Larry Fink thinks investors should expect just 4% returns over the next 10 years. However, Fink also said we will see another leg up in this market and weighs in on what he thinks is driving stocks to record levels.
You already know my thoughts, it's as good as it gets for stocks, so book your profits and plow your money in boring old US long bonds (TLT) if you want to sleep well at night.
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