Here’s part two of the Q&A on passive investing. If you haven’t read part 1 it will be helpful to do that first since I laid out the necessary definitions and foundation for a clear discussion.
I answered Marks’ first question about passive investing in the first post, but as it was running a little long I didn’t get to the next four. So let’s bang those out:
Question 2: “What are the implications of passive investing for active investing?”
Marks goes on to specifically ask: “what happens when the majority of equity investment comes to be managed passively?”
This is literally impossible. Indexers are one half of a trade. In order for an indexer to be able to buy an index there must be a more active investor or market maker taking the other side of the trade. It is impossible for “the majority” of equity investment to become passively managed since less active investors rely on more active investors to create liquid markets in which they can even operate.
But I think we need to go back to the fact that more and more index funds are becoming fundamentally based funds. That is, they are actually studying the underlying companies and trying to buy and sell based on fundamental factors. So, let’s say all stock analysis is either growth or value fundamental analysis – a world in which there are a lot of low cost systematic value based fundamental index funds AND a lot of low cost systematic growth based fundamental index funds is really no difference from a world where high fee active value and growth funds are the dominant funds. The main difference is that the customers save a whole bunch of money in this new world.
Question 3: “Does passive and index investing distort stock prices?”
Marks isn’t real clear on this one but does seem to think that ETFs are distorting prices higher to some degree or that the rise of passive investing makes equities potentially riskier as outflows could lead to more exaggerated declines. I’ve touched on this one in the past and I think there’s a shred of truth to it. But not for the reasons that Marks cites. My bigger concern is that the people who are pouring into these ETFs are not doing so within the parameters of their risk profiles. They are mostly being told “hey, stocks will fall a whole bunch at some point and when they you should just hold for the long-term because stocks always go up in the long-term”. That’s nice thinking in theory and really hard to do in reality. So there’s a risk that the flood of new investors who are overweight equities will realize that their risk profiles are wrong at exactly the wrong time and this could exaggerate the swings in the market on the downside.
But I don’t want to over-exaggerate this point. The equity markets have always been risky and they’re always procyclical. People always pour in late and get out late. It’s just human nature with money. Do ETFs exaggerate this impact? Yes and no. Remember, on the other side of an ETF seller is a more active buyer. So, to assume that the ETF sellers will exaggerate the downside is to assume that the more active buyers will allow bargains to persist. Color me skeptical on that one.
Question 4 – “Can the process of investing in indices be improved relative to simply buying the stocks in proportion to their market capitalizations, as the indices are constituted?”
YES! Marks clearly agrees. Deviating from global market cap weight is smart. It is perfectly fine to be an active investor assuming you do so in a low fee and tax efficient manner. But I also think we have to be careful about this development. A lot of what is being sold as “passive” investing is really just a newish form of high fee active investing. This is the main reason why I think the terminology is so important here. In a world where anything can be “indexed” passively the word passive loses its meaning. A hedge fund that is linked to a passive index in an ETF format with an inefficient tax structure, poor relative performance to a proper benchmark index and high fees is clearly not very passive. So yes, we’re seeing a huge amount of growth in newer indexing strategies that are very different from market cap weighted funds and that’s a good thing. But we need to be careful about the same old high fee tricks being played with new marketing.
Question 5 – “Is there anything innately wrong with ETFs and their popularity?”
Marks notes that ETFs can be dangerous because they mislead the investor into believing there is liquidity where there really isn’t. He’s certainly right about this to some degree. The fact that you can see ETF prices daily is increasing the risk of short-termism in many products. For instance, no one needs to be able to see the daily price of a 5 year constant maturity bond ETF, but the daily ups and downs expose the investor to actually seeing the price of the instrument on a daily basis and making them think it’s riskier than it really is.
Or, as Marks notes, there could be times when bonds are illiquid and the ETF doesn’t actually reflect the proper prices of the underlying bonds. This happened 3 years ago during the China Flash Crash and I pointed it out in real-time as I was buying massively discounted ETFs because the prices were clearly wrong. But make no mistake, this is not a product error. This is simply an investor error due to the fact that some people don’t understand what they own.
In my view, this liquidity feature is a strength and not a flaw in ETFs. To me, the liquidity of ETFs is like having a beer tap in your house that never goes dry. Yeah, in theory you could drink from it all day. But in reality you need to understand that the constant liquidity of that beer tap is likely to kill you if you abuse it.
Marks’ last comment gets at the bottom line:
“The bottom line is that the wisdom of investing passively depends, ironically, on some people investing actively. When active investing is dismissed totally and all active efforts cease, passive investing will become imprudent and opportunities for superior returns from active investing will reemerge. At least that’s the way I see it.”
Remember, there’s two sides to every trade. The less active investor relies on a more active investor to make a market in the stocks that they want to own in an index. So it is literally impossible for the market to become nothing but indexers. And once you understand that point most of the other worries about the rise of indexing become narratives that sound a lot scarier than they really are.