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Passive Proliferation – A Snake Eating Its Own Tail

Written by David Robertson | Jun 7, 2019

Passive funds have come a long, long way from their humble beginnings. Having started as small and scrappy and distinctly out-of-consensus investment options, they have grown impressively over the last ten years and now are often considered the defaults for many investing activities.

As passives have grown, however, an important dynamic has changed. When passive funds comprised only a small part of the total market, it didn’t matter much that they allocated capital according to criteria that were entirely unrelated to economic fundamentals. As a much larger (and still growing) mass of funds, this quirk is having a progressively greater effect on market prices.

Although few would be surprised that passive funds have been gaining share at the expense of active funds, the extent of that progress is not often highlighted. This makes the recent Morningstar Direct Fund Flows Commentary from April 2019 (h/t Almost Daily Grants) all the more newsworthy. The report noted that:

“A $39 billion inflow in passively-managed assets in April pushed the total to $4.3 trillion, within $6 billion of eclipsing the total assets invested in active management”.

Kevin McDevitt, who authored the report noted, “This is a milestone that has been a long time coming as the trend toward low-cost fund investing has gained momentum.” Further, almost all the growth in passives has been funded by flows out of active funds. As McDevitt highlighted, “active U.S. equity managers have seen funds decrease in every year since 2006”.

Coincident with the passive share milestone, a couple of studies appeared in the recent Financial Analysts Journal that speak to some increasingly visible problems with passive investing. The first, entitled, “The revenge of the stock pickers“, focuses on the awkward and often inefficient ways in which ETFs discount thematic news:

“When an exchange-traded fund (ETF) trades heavily around a theme, correlations among its constituents increase significantly. Even some securities that have little to no exposure to the theme itself begin to trade in lock-step with other ETF constituents. In other words, because ETF investors are agnostic to security-level information, they often ‘throw that baby out with the bathwater’.”

Of course, this is the type of thing that causes active investors to salivate at the opportunity. Indeed, the authors confirm, “When high-volume selloffs occur, ETF investors may be leaving as much as 200-300 bps of alpha on the table for stock pickers to capture over the following 40 days.” The opportunity for the active investor is conditioned on only two basic questions: “Why is the ETF selling off, and should this constituent be selling off with it?”

Often the answers are not hard to find. The article outlined the example of pharmaceutical stocks in September 2015. At that time the New York Times reported Turing Pharmaceuticals had massively increased the price of a life-saving drug. The next day, presidential candidate Hillary Clinton tweeted that she would develop a plan to curtail price gouging by pharmaceutical firms. A week later, Valeant Pharmaceuticals was scrutinized by the House of Representatives in regard to drug price increases. These headlines had an interesting effect on the Health Care Select Sector SPDR ETF (XLV):

“Both these events threatened to put pressure on revenues for the pharmaceuticals sector but not necessarily for other health care stocks. Although some companies were directly in the line of fire, we find it hard to imagine how regulation aimed at human drug pricing would affect companies that make animal medicines and vaccines, such as Zoetis, or medical equipment, such as Baxter International. Yet all XLV constituents-without exception-sold off over these seven trading days.”

In other words, it very much appears as if the baby got thrown out with the bathwater. Stocks like Baxter and Zoetis should not have been affected at all by pharmaceutical headlines but were affected simply by virtue of being in the healthcare index. This shouldn’t happen when a market is effective at determines prices.

Another area in which the value proposition of passives can be less than it seems is in the area of factor investing. Factor investing (aka, smart beta) is a form of passive investing in that it foregoes security-level analysis. Rather, it identifies certain “factors” that tend to generate premium returns over time. “Value”, for example, is a well-known factor.

Another factor is “quality” and it is reviewed in the study, “What is quality?“. One of the unique aspects of this particular factor is that there are fairly disparate views as to what constitutes quality. Various funds use very different inputs to capture the essence of quality.

In the authors’ review of literature on the “quality” factor, they find that “profitability, investment (asset growth), accounting quality, and payout/dilution are all strongly related to future return.” Conversely, they also find that the commonly used metrics of “capital structure, earnings stability, and growth in profitability show little evidence of premium.”

So, one point is that the metrics for “quality” that have been demonstrably effective tend to be the same ones that any decent student of finance, or decent CFA charterholder, or decent securities analyst have been trained to identify. The main difference is that factor funds try to do so cheaply and systematically but often superficially, and analysts dig in to confirm economic reality but at a higher cost.

Another point is that at least some “quality” factor funds don’t do what they are supposed to do. Most of the “quality” funds that were examined include metrics that have no evidence of adding value. One of the funds uses only metrics that have no evidence of adding value.

As such, to a greater or lesser degree, most of the “quality” factor funds are more marketing phenomena than they are interesting investment vehicles. They lend credence to the adage that smart beta is simply the combination of smart marketing and dumb beta. They also indicate how alluring narratives and other marketing tools are increasingly tarnishing the field of passive products.

The trend in passives to more aggressively exploit marketing narratives was also revealed by Zerohedge in discussing the “Next Generation of ETFs“. In the increasingly competitive field of passive products, not only is there a need to develop new product ideas in order to keep expanding, but there is a need to raise fees from the paltry levels of the largest, most commoditized funds.

As the story highlights, “While a normal ETF collects fees of as little as $0.20 on every $1,000 invested, AI [artificial intelligence] designed ETFs can justify fees as large as $1.80 to $8 on that same $1,000 investment.” There is no small irony that increasingly aggressive and dubious marketing claims that are designed to increase fees are infecting the field of passive investing. The same types of criticisms that were used by passive funds to gain share at the expense of active funds now applies to those very same passive funds.

While the two FAJ articles highlight some pockets where things can go wrong with passive investing, they only hint at the broader impact passives can have. This broader impact can best be understood as an imbalance. When trading is dominated by active funds, the parties have economic incentives to get the transaction price as right as possible. This keeps prices anchored to economic realities.

When trading becomes dominated by passive funds, however, and passive funds gain share at the expense of active funds (as they have over the last several years), there is no mechanism to anchor prices to economic reality.

Horizon Kinetics reported on this phenomenon in its 4th Quarter 2016 commentary. They describe how “the money flows into index funds pushed up the prices of the index-centric securities”.  They add, at the same time, “the outflow from actively managed funds … has forced active managers to sell and push down the prices of that which they own.” Both trends affect prices in ways that are wholly unrelated to fundamentals.

There are two important consequences of these trends. One is that the growth in passives will slow down:

“But long before such exhaustion of the pool of actively managed equity mutual fund AUM, those outflows must decline significantly. They don’t just continue at a steady rate, then stop on a dime. Moreover, there is some significant number of investors who prefer and will maintain their actively managed assets. Is it 10%, 30%, 40%, of the total equity? So the limit is even closer. And it’s even closer than that, because to keep the perceived equilibrium going, the index fund organizers need to go beyond merely continued net inflow; they need proportionately increased flow, because the market value of everything they are buying is going up; it’s a law of large numbers dynamic. They need more and more money to hold the prices where they are, but the inflow is being drained from a shrinking pool of non-indexed AUM. That’s how all bubbles work.”

A second consequence is that market prices have become progressively more detached from underlying economic fundamentals. How far can valuations get stretched? The folks at Horizon Kinetics provide some color:

“We do not know where the tipping point is. But the minute the inflows [from passives] slow meaningfully, whether that takes three years or ten, the index will no longer set the price, the ETFs will no longer be setting the prices of the winners. At that point, the baton passes to the active managers, and they will set the marginal price.”

So, there are some fairly powerful lessons for investors here. When the baton passes to active investors and they begin setting the marginal price again, there is potential for stocks to go down significantly from current levels. The reason is that active managers set prices according to fundamentals and valuation and passive managers don’t. It is not that fundamentals and valuation have not mattered over the last nine years; it is only that they haven’t mattered to the setters of marginal prices during that period.

Another important point is that change is imminent. Now that passives comprise half of managed funds, there is little room for continued growth at the same rates. As Horizon Kinetics points out, passives “need more and more money to hold the prices where they are, but the inflow is being drained from a shrinking pool of non-indexed AUM.” It’s only a matter of time before that growth must slow.

In addition, whatever selloff might happen could be substantially magnified by a slowdown in corporate share repurchases. Just like passive funds, corporations have also been large purchases of stock and have also been largely insensitive to price in doing so. If share repurchases decline from record levels, it would exacerbate the effect of slowing passive flows.

Further, the success of passive investing has affected the active money management industry in a number of ways. Many active managers have not been able to withstand the performance pressures and have closed down. Many of those who have survived have done so by adapting their approaches to favor money flows over valuation in their analyses. Either way, much of the industry has lost its “muscle memory” for doing rigorous valuation work.

Finally, the 50% milestone creates an excellent opportunity to reflect on the value proposition of passive funds. Since that value proposition is predicated on low cost exposure to something desirable, and the desirability of risk assets depends on prices representing fair value (which translates into adequate expected returns), it also depends on the balance between active and passive investing.

The more passive funds set prices, though, the less balance there is, and the more disconnected prices can stray from economic reality. The result is that owning passive funds simply exposes investors to overvalued assets. In other words, passive funds are becoming victims of their own success by becoming too big to offer the same value proposition they once did.

As a result, the 50% milestone also serves as a warning signal to passive and active investors alike. It signals that the greatest benefits of passive investing are mostly over and are unlikely to ever be repeated to the same degree. It also signals an investment landscape featuring security and entire asset class valuations that are substantially above fair value. Indeed, the balance between passive and active investing may be a more important indicator for investors than either interest rates or economic growth. The bad news is that returns are likely to be poor for the foreseeable future. The good news is that this environment is setting up to be one in which truly active managers are well suited to outperform.


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David Robertson CFA is the CEO of Areté Asset Management and founded Areté with the mission of helping people to get the most out of their investing activities. Most of his career has focused on researching stocks and markets, valuing securities, and managing portfolios for mutual funds, institutional accounts, and individuals. He has a BA in math from Grinnell College and a Masters of Management from the Kellogg School of Management at Northwestern University. Follow Dave on LinkedIn and Twitter.

2019/06/07
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