The potential implications of too much of a ‘good thing’
Most investors are aware that inflows to passive funds have significantly upstaged those into actively managed equity disciplines since the Global Financial Crisis. In fact, as chart 1 illustrates, actively managed US equity assets outnumbered passive by three to one in mid-March 2009, when major stock indices began to reverse their negative trend and embark on what has been so far a massive, secular bull market. The following chart provides a clear indication as to the sheer pace of asset flows into ‘tracker’ and exchange-traded funds (ETFs) in recent years, with the gap between actively managed and passive assets coming close to parity.
Chart 1: Growth of flows into active and passively management funds
The Morningstar analysis is supported by independent data from Bank of America Merrill Lynch, which finds that overall market share of US passive equity funds has now risen to 45%1. Yet, the rapid penetration of these price momentum-based strategies leads us to consider the question of whether further growth could result in a narrowing of the leadership base, by virtue of their ‘buy-the-biggest first’ approach, and potentially further inflate equity bubbles, as recently exemplified by the so-called FAANG stocks.
In long-term bull markets the emphasis tends to be on owning ‘the market’ rather than a fundamentally based portfolio of individual stocks – a scenario that has arguably been amplified in the current bull market due to the unprecedented levels of extreme central bank intervention. And, in terms of net-of-fees performance, investors have unquestionably benefited, but will this ‘commoditised approach’ to idiosyncratic securities continue to deliver now that the balance has shifted so dramatically?
In order to answer this question, it is important to recognise long-term investment success in risk assets is rarely about the present ‘snapshot in time’. Therefore, despite a decade or more of incontrovertible success, we believe the salient issue is that passive strategies are not in any way forward thinking. In fact, basing allocations on the current market capitalisation of stocks is effectively a long, momentum strategy which buys high and sells low. Obviously, the inclusion of tracker funds in a balanced portfolio can help constrain management costs and this is a good thing. These tracker funds, however, may no longer be the panacea they appear to have been during the last decade. There is a concern that persistent flows into strategies that ‘buy-the-biggest-stocks-first’ could create dislocations in asset prices that can only be addressed by a more active investment approach and can only work if there is a balanced split between investment approaches. The whole concept of passive investing is reliant on markets being efficient with reasonably fair asset prices. Rather than constituting a new paradigm, a fund management industry that starts to draw close to 100% passive would fundamentally disrupt this balance and could have decidedly negative consequences.
To illustrate this point, we have adapted the principles of The Laffer Curve. The Laffer Curve was originally designed to illustrate the concept of ‘peak taxation’. In simple terms, there has to be a point where the tax rate is optimal. If tax rates are too low, exchequer revenues are insufficient. Similarly, when tax rates become overly punitive, exchequer revenues will fall rather than rise as labour is withdrawn. This supports the notion of finding the right balance between output and entrepreneurial incentives (to maximise economic production) and punitive tax regimes (which dis-incentivise enterprise and economic gain).
There is an obvious analogy with asset management here (see chart 2). Clearly, when the percentage of passively managed investments is zero, investors are paying high levels of performance fees and should expect their selected managers to be running portfolios with high tracking errors to justify these ‘full’ active management costs. As has been proven, assigning a percentage of portfolio assets to passive disciplines can increase overall efficiency in net-of-fees terms. But only to a certain point. As we shall go on to explain, we believe too much passive can actually lead to performance decay in exactly the same way as too much tax depletes exchequer revenues.
In the 1800s, the sociological historian and philosopher Thomas Malthus defined the concept of population growth as being governed by the relative plenitude of survival necessities. As such, growth would naturally be stymied by the insufficiency of food and water supplies to nourish the greater population, only to accelerate again once the population had receded to a more sustainable level. This notion of increasing mortality being directly correlated to population growth became known as “Malthus’s Revenge”.
Similarly, in an active versus passive context, the sustainability of the rewards available from passive investment are contingent on active managers being entrusted with sufficient client assets to act as a natural counter-balance to the ‘blind’ pricing momentum associated with exorbitant flows to index trackers and exchange traded funds. This is especially the case in respect of stocks such as Apple which feature in vast numbers of indices and specialist ETFs (according to the ETF Database, the FAANG stocks are constituents of no fewer than 37 ETFs in the US alone). We believe truly active investment management can help to ensure that the valuations of securities do not become excessively distanced from fundamental fairness, thus creating a more efficient market which is less risky for passive vehicles and their investors to operate in. It is not difficult to envisage that the passive movement could effectively ‘eat itself’ in the absence of such a corrective force (we would describe such a scenario as “Laffer’s Vengeance”). This view is shared by John Authers (the former chief markets commentator for the Financial Times) who, in August 2018, wrote that ‘a stock market in which nobody is attempting to work out which stocks are cheap and which expensive, and then buy and sell accordingly, ceases to be a market.’
Consequently, in the same way that a taxation rate of 100% will inevitably lead to zero exchequer revenues, we believe an asset management industry that is 100% passive can only deliver zero returns for two reasons. Firstly, it would prove impossible to find a counterparty to a buy or sell order if all fund managers are doing the same thing. Secondly, if we discount the waning influence of day-traders investing for their personal accounts, one fund can only outperform at the expense of another fund in its peer group; if they are all trading pari passu, theoretical fund returns must be zero.
Clearly, an entirely dysfunctional stock market would not only jeopardise returns for investors, but would also choke off an invaluable source of entrepreneurial capital – the economic implications could be truly disastrous.
If the flow into passive strategies continues to rapidly increase, there is a concern that active managers, seeking to add value from fundamental analysis, could become increasingly ‘gazumped’ by the sheer scale of these flows; active management could lose its power to act as a corrective force to extreme price momentum among certain stocks. If investment capital is repeatedly misallocated, markets become increasingly inefficient, degrading the level of investment return.
We would argue that excessive momentum towards the so-called FAANG stocks, regardless of whether the flows come from pure index players, quasi-trackers or momentum investors, is no more logical (in the absence of a fundamental rationale at the individual stock level) than chasing TMT (technology, media and telecommunications) stocks at ‘telephone number’ price / earnings multiples at the turn of the Millennium. Something will have to give sooner or later.
Two questions arise:
At what point will the passive movement and its investors appreciate that the paradigm becomes unsustainable beyond a peak level of dominance?
Will active management come sufficiently back into favour before we hit the point of no return (literally and metaphorically)?
The problem with the concept of peak passive is that it is extremely difficult to define. Academic estimates typically lie in the range of 25-45%, which is not exactly narrow and the upper level has already been surpassed in the US. Clearly, the risk-off / risk-on behaviour we have witnessed in recent years is indicative of investors moving in and out of the market, rather than constituting the cyclically based sector rotation which is more typical of the mature phase of a bull market. This has resulted in higher cross-asset correlations and lower dispersion at the sector and stock level.
The crisis-induced slump of 2008 is often referred to as a ‘correlation 1’ event because prices moved in lock-step across and within asset classes. Investors might therefore infer that such indiscriminate sell-offs are typical, but historical analysis demonstrates that this is the exception rather than the rule. According to FactorResearch2 correlations have been much lower in earlier crashes, providing the potential for active managers to deliver some downside insulation to their investors by avoiding the biggest losers. As Tom Stevenson observed in a recent Daily Telegraph article3 in the next downturn ‘it might not seem so clever to just buy [or hold] everything…the prospects for individual companies might suddenly seem more relevant.’
If the trend towards passive management remains unchecked – Moody’s, the rating agency recently forecast4 that the assets of active funds would be surpassed by passive in 2021 – the longer-term consequences are potentially far greater than a few basis points of investment return. In terms of passive investment exposure, the old adage ‘too much of a good thing’ seems wholly applicable.