Fear and loathing in asset management

Today I listened to a presentation that was one part screed against passive investing and one part shameless plug for sexy, paradigm-changing growth stocks. I will not mention the name of the presenting firm because it is irrelevant for the purposes of this blog. I am more concerned with the substance of the presenter’s arguments.

Assertion #1: Index investing distorts capital markets by inefficiently allocating capital

Rebuttal: This one is easy. Index funds buy shares on the secondary market. Companies raise capital in the primary market, in which index funds do not participate. While trading activity by index funds certainly impacts share prices, the contention that index funds distort activity in the primary market doesn’t hold much water. Index funds may influence financing decisions at the margins (should we raise debt or equity to finance a new factory?), however the impact of index funds on this decision pales in comparison to prevailing interest rates and tax policy. If capital allocation is going to keep investors up at night, they should be far more concerned with distortions and malinvestment driven by central bank policy actions, such as negative interest rates in Europe and Japan.

This is not the first time this argument has been trotted out and it certainly will not be the last. In August 2016 Bernstein published a research note titled: “The Silent Road to Serfdom: Why Passive Investing is Worse Than Marxism” (you couldn’t make this stuff up). It featured the below paragraph, which reads like something issued from the deepest bowels of The Ministry of Asset Management Propaganda:

We show later in this report that active investing, by seeking to understand ex ante what the ‘fair value’ price of an asset, or an equilibrium price level for an industry is, and allocating capital accordingly, helps the process of price discovery to occur much faster than would otherwise be the case. This has clear social and economic benefits compared with a passive regime where capital flows at best do not help, and indeed can hinder, the price discovery process. We would argue that, by virtue of being forward looking, a process of planning of capital allocation in a Marxist society could by similar logic be superior to a largely passive regime where the capital allocation is done by a marginal participant based on past performance and without any regard to industry dynamics or deviations from fair value. Whether or not any planning process can ‘beat’ fully functioning capital markets with a meaningful share of AUM run actively, we can envisage such a process being more effective than largely passive capital markets at allocating capital- and so a Marxist regime being superior to a capitalist system with little or no active management.

This is possibly the most extraordinary straw man I have seen in my career.

Assertion #2: Index investors are buying a backward-looking view of markets. Therefore index investors will miss out on the impending technologically induced disruption of our entire society

Rebuttal: This argument resonates more with me, although I take issue with the “backward-looking” characterization of index investing. The index investor seeks to piggyback on the work of active traders at low cost. The theoretical underpinning of index investing is that markets are efficient and thus price assets perfectly. Market prices therefore should reflect all available information about a stock, including expectations for future growth and profitability. If markets did not attempt to price future growth, you would not see certain stocks trade on triple digit earnings multiples.

There are certainly conditions under which indexing might impede price discovery and market liquidity, but it’s not like we are seeing some huge blowout in bid-offer spreads for S&P 500 stocks. And even if we are facing a less efficient market as a result of the trend toward passive investing, that should be a thrilling development for skilled investment managers. It should create more opportunities for stock picking.

Inasmuch as the new market paradigm is concerned, you would think from the tone of the presentation that the firm assembled a portfolio of niche ideas you couldn’t possibly own in passive form. And yet, what are The Companies Of The Future? Amazon, Activision Blizzard, Nvidia. The list goes on.

Can you guess the overlap with those names and the Russell 1000 Growth Index? Hint: it is high. Can you guess the level of sell-side research coverage for those stocks? Hint: it is not low.

On the basis of this presentation you would also think this was the first time in history markets had been on the cusp of transformative change, and that index funds were totally untested in periods of market and industry dislocation. You would never suspect that VFINX has been around since 1976. You would certainly be surprised to learn that index funds had weathered multiple financial crises, boom-bust cycles in commodities and credit, the rise of the internet – need I go on?

Reading this you might think I am some passive investing fanatic. I am not. I do not believe markets are perfectly efficient. Valuations matter. In my view the ETF world has clearly gone overboard with faddy, thematic products – not to mention solutions in desperate search of a problem. What individual or institutional portfolio needs 3x levered exposure to gold miners? Or 2x levered exposure to China A Shares? That’s just gambling packaged in a “passive” wrapper.

Yet despite all this, investment managers do themselves no favors trotting out tired, straw man arguments to combat what is clearly an existential threat to their business models. It reeks of desperation, and you can pick up the stench from a distance.

Morningstar columnist John Rekenthaler attacked this issue from a bit of a different angle in a recent article, concluding:

There will always be arguments against indexing. If passive funds never existed, traditional fund managers would be collecting an additional $40 billion in annual fees (roughly speaking, $5 trillion held by index mutual funds and exchange-traded funds times 0.80% for actively managed funds’ expense ratios). When $40 billion are put into play, people fight.

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This post was written for entertainment purposes only and does not represent a recommendation to buy or sell securities, or to pursue any particular investment strategy. Prior to buying or selling securities, readers should consult with a financial advisor who can advise them based on their unique individual circumstances.

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