As the market recovers from the Great Recession and continues to decline, we hear the cry of a rally: “It is a stock picker market“
This proved to be wrong for the better part of the next decade. And so the cry of the assembly turned into: “Just wait until the next crash – indicators will be damaged, and active managers will improve! “
That too was proved wrong. Just as Icarus’ wings melted when he flew too close to the sun, so did the high-beta, unprofitable, high-volatile holdings that burned to the ground in 2020 to meet the Best Performance Fund. After their intense pace, they were just as upset as the favorites in the Kentucky Derby. An ultra-fast motion similarly reverses thoroughbreds and concentrated portfolios.
Fast but steady derby wins, slow but steady market wins. But very fast, paddle-to-the-medal, hypersonic motion has been proven to undo almost everything. The simple reason is: It is sustainable.
It’s been a good run since the end of the epidemic crash. But the Fed’s housing is about to run out; Most pigs (aka fiscal stimulus) are through pythons. Markets are slowly recognizing this and thus investors are re-evaluating their expectations.1
In light of this, we have thrown new spaghetti against the wall: “Passive indexing is disrupting the market, leading to increased instability, curtosis,2 And price (elasticity).
This is a change from the previous description. Since GFC is low, the story goes something like this:
1. Going to lose the active passive during the bull race! (No)
2. Bear time will beat stock picking and market time indexing (worse)
3. Instability! Drawdowns! Crush! Indexing is behind all this shit! (LOLZ)
In light of that progress, it is probably worthwhile to discuss the impact of investors, their portfolios and market indicators and explain why. Despite the best efforts of the mercenaries, it is trying to show otherwise – Low cost, passive indexing is not the root of all evil.3
Some Backstory: Multiple histories have been written about the rise of the index from the academic backwaters. For more details, read Robin Wigglesworth’s “Trillions” and Eric Balchunas’s “The Bogle Effect”.4 Both entertaining and well written.
The tl: ড In both books, the traditional mutual fund evolved into an era where we were literally unaware of what efficacy it brings; Or what it has done against it is not well understood. We’ve learned three key elements since then:
1. A handful of stocks are the main drivers of the market for a long time;
2. Managers may be good stock pickers but they are terrible holders and stock sellers; And
3. Cost is a key driver of long-term returns.5
This modern, simple yet important understanding was in my head when I raised this question with the public:
Can anyone explain to me how all this displacement and instability is somehow caused by low cost passive indexing?
– Barry Ritholtz (@Rithaltz) May 5, 2022
The tweet bids farewell to many to bring their favorite Shivaleths to the fore.6 But it did lead me to a weekend conversation with Dave Nadig about the structure of the market: how different methods of investing create different kinds of effects. I suggest you go read his acceptance here: The ethics of indexing redox.
I am less concerned with theoretical or abstract effects on trading and market structure; It’s not like I’m fishing in a pond. Rather, my focus is on what is the best way for investors to raise their capital as a whole. And it is impossible to look at the impact of the passive and conclude that the vast majority of market changes caused by low-value indices have worked for the benefit of individual and institutional investors alike – whether they are indices or not.
This represents an existential threat to most of the financial services. It is difficult to get (extra) fees from investors who have just decided to “buy the market”.7 This approach has pressured almost everyone in the industry, from entrepreneurs to analysts to the type of active management. And it has reduced fees for indexers and non-indexers alike. In a zero-sum world, someone has to be The wrong side of trade.
All this well-trod soil; We’ve discussed the challenges of active management in a dozen plus columns and why the Vanguard Group has been so successful in a dozen more.
To be fair, some things are different today:
We know that low-cost indexing continues to gain market share at the expense of poorly-functioning active funds and all kinds of high-value funds. There are some effects of variable balance and Dave does an excellent job of summarizing them.
But there are many more reasons to clearly tease the true effect of passive in the market. High-frequency trading (HFT) affects market structures, such as quantitative easing (QE), zero interest rate policy (ZIRP), corporate governance, venture capital, qualified small business stocks (QSBS), direct indices, revenue stimulus, CARs. , Tax code changes such as 2017 TCJA, Opportunity Zone etc.
I would like to acknowledge that passive is a factor in the way the market has evolved and adapted. Its increased market share is affecting trading, expiration of options, market structure, etc. Perhaps around the edge, it even affects price discovery – something that should work to the advantage of clever active managers. But there are many other reasons to mention the same. And indexing has yet to prove to be anything other than a benign effect.
Bottom line: The low-cost index has been a huge boon for investors; Critics have failed to make a compelling case against it, and besides, all of its critics seem to have a vested interest in the other side of the trade.
The Ethics of Indexing Redox (Dave Nadig, May 11, 2022)
Index funds are the root of all evil (December 19, 2018)
Winner accepts all applicable for stock (August 1, 2019)
Instability was supposed to help active managers (May 1, 2019)
Fund managers are good buyers but terrible sellers (January 23, 2019)
Vanguard Low Fee, June 2, 2017 Protected
The Best Investment Tips You’ll Never Get (February 21, 2014)
1. I believe this is just a return, but I will save that discussion for another time …
2. Don’t ask.
Instead of asking, read: “Finding the Source of Financial Fluctuations: The Elastic Markets Hypothesis” (hat tip) Corey Huffstein)
3. As we discussed a few years ago, this is McKinsey & Co.
4. MiB with Wigglesworth here; MiB with balcony is coming next month.
5. As Balchunas discusses in this part of Bloomberg, Jack Bogle’s relentless focus on cost-cutting Vanguard Group has saved investors literally trillions of dollars in fees.
6. In this kind of debate, many have only one hammer and so we go to find the nail.
7. See this God-fearing analysis for an example of a deeply flawed acceptance: “Your love for index funds is terrible for our economy“