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Podcast: FALLACY of Index Funds!

publication date: Oct 23, 2016
 | 
author/source: Brian Nelson, CFA

The Valuentum Analyst team digs deep into the logical fallacy that paved the way for index funds, and the very real risks investors take while driving with their hands off the wheel looking only through the rear-view mirror.

Summary

Please read the first 3 minutes of the presentation (there is no audio at the beginning). Pause the program if you require more time to read.

If you still don't see the FALLACY that paved the way for the creation of index funds, be sure to comment below.

The last 10 minutes of the program comprises a discussion by the Valuentum team of active versus passive. Looking forward to a good discussion.

Please be sure to view the transcript below if you are short on time.

Tickerized for broad market ETFs.

Kris Rosemann:

Hello -- and welcome to the Valuentum Securities’ podcast. My name is Kris Rosemann and with me are Chris Araos and Brian Nelson. Brian – recently, we have seen a massive flow of funds into passive mutual funds and ETFs; specifically, $1.3 trillion has been added to passive mutual funds and ETFs in the three-year period ending August 31 2016, and $250 billion of that was actually identified as being drained from actively-managed funds. I was wondering if you could speak a little bit to the dynamic what you think might be driving the demand for investors to take their money from an actively-managed account to passively-managed funds.

Brian Nelson, CFA:

Sure.

I think there are a number of things going on. I think the fund performance across the board -- large cap, mid cap, and small cap fund managers -- has been atrocious over the past five years, with some stats saying 90% of fund managers are trailing their respective index, which is absolutely remarkable. I think that the case is being made -- from regulators in some cases and lawyers in other cases -- what is the justification for having active management if all these fund managers are trailing? So what we’ve witnessed is -- I think -- scare tactics where money is flowing away from active management. I think there’s also something to be said about the leverage within the financial advisors business model where they can leverage more clients through passive indexing strategies that don’t require a lot of maintenance relative to individual stock selection.

So there’s been a trend not only on the poor performance on the data side but also in the regulatory legal environment. Then, of course, the business models of financial advisors are letting themselves more passive management. This is a trend that’s been -- I think -- evolving over time, but one of the interesting things about this dynamic is that as more and more people index, the possibility/probability for generating outsize returns increases for active management. As of right now, passive managers, the reason why costs are lower is they’re outsourcing what I would describe to be price discovery, meaning that the active fund managers are the ones that are buying and selling individual equities and in determining the pricing dynamics, whereas the index indexers are not as interested in that but really riding the wave...

Kris:

You use the term there “riding this wave,” and one of the things that I wonder is -- is it really a wave and will this wave crest or peak as they say? What can we do to kind of point to some tipping points that might show us that wave is getting ready to peak? I’m not sure what we can really do to accurately foresee that. I mean even Richard Thaler who is an arguer against the efficient-market hypothesis, which is something that is kind of core to the idea the underlying ideals of index investing is that markets are efficient. Even he is ready and willing to admit that it’s nearly impossible to predict and explain when and where bubbles happen and how and when they will burst. So that’s something very difficult to identify, and I just wonder if this is going to be a cycle that we’re going to see, where we’re going to ride this wave of indexing until there is a catalyst for a correction and then investors realize the added benefits of having an active manager and slowly move in the other direction.

Brian:

I think your right Kris -- and part of the reason is that the returns of an indexing strategy have been so good. But it wouldn’t be out of the question to see a market return down ten, fifteen, twenty percent in any given year, and then the indexing strategy doesn’t look so great anymore and indexers start asking themselves whether an active manager could have saved them from losing -- you know -- one-fifth of their retirement. We can see pretty large erosion of capital, and right now things are great – the indexing strategy is working, but time and time again, we see strategies come in and out of favor, at least from the trajectory of fund flows. I think that might be the case -- the catalyst for active management coming back into force, just poor market performance where really good asset allocators and stock selectors will outperform in a down market. I think once that materializes I think that there will be money that flows back into the active side of things. That’s kind of where I think the eventual catalyst occurs.

But you know there’s a lot to be said about the benefits of indexing, in general, especially for the average investor that doesn’t want to actively search out their own stocks so I wouldn’t say that indexing is a bad thing for all types of investors. But I do think that there are some investors that are indexing today that might be better suited with having active management in their “buckets.” By definition, passive management cannot possibly become 100% of the market -- there will always be room for active management and that’s because if there is nobody looking at the stock market, you don’t really have a market. People (would) just putting their money in a bucket and not even looking at it and care where it goes, per say. Then you don’t have any reasonable market, and that’s just not going to happen anytime soon.

Some even argue that even indexing is in some respects an active strategy. We go back and look at the original construction of the S&P 500, somebody picked those stocks to be in the S&P 500. They set the rules, they set the dynamics and if that’s not active I don’t know what is -- and that index has changed significantly over the years. I think what you have here is really a comparison in many respects -- benchmarks, indexes -- between various levels of active management. I don’t think there’s anything completely passive about indexing. So right now we’re seeing a wave of people moving into passive investing because they’re managing their costs hoping that leads to outperformance using the history as a guide as to why that outperformance has occurred. It’s always easy to promote an indexing strategy when the market is at all-time highs.

If we had looked at the indexing strategy at the depths of the latest Financial Crisis of 2009 one might find that this passive management thing isn’t all that great. A lot of the historical studies if they were completed at the March 2009 panic bottom would have different outcomes. So when you measure studies, how you measure studies always matters. At the end of the day, there’s just something to be said about having someone actively looking over ideas, and making sure things aren’t out of whack. So I’m a proponent that -- I probably have fallen into the Richard Thaler camp, where an investor has reason where a hands off mechanical indexing strategy may not have that oversight that’s necessary in times of outliers, both on the upside and downside.

Kris:

I wonder sometimes if it’s possible for the massive flow of funds to passively-managed funds or indexes if that could be making the active asset manager’s job that much more difficult -- not only in the sense that $250 billion have been taken from their funds in the past three years, but in that all of these funds are going into passively-managed funds, passively-managed ETFs, and so they’re being distributed amongst these stocks that aren’t really being picked by anybody, so lifting all the boats – a rising tide lifts all boats, as the saying goes. I just wonder what impact that could have on actively-managed funds and the valuation of markets in general as we continue to see them stretched in the current market.

Brian:

Yeah -- that is an interesting dynamic. If everybody is just throwing money at an asset class being equities as in the case of indexing, things can get really overheated -- and indiscriminate buying of something is how bubbles are created. Now -- maybe you can’t recognize them as they are happening, but indexing -- I think -- is in some respects supported by rearview mirror driving without your hands on the wheel. If you think about that, it does not take a lot of attention or effort to be in that situation, but is it dangerous?

Yeah, it’s dangerous, but so is driving and that’s active management. With active management you’re at least looking forward, and you know what’s behind as you’re glancing in your mirrors. I think indiscriminate buying is how bubbles are created, and if it’s not based on reasonable analytical forecasts, then you can get lofty P/E ratios. One pays attention to their bill at the grocery store when they’re buying groceries, but they’re not going to pay attention to what they pay for on their investments in their stocks? That they’re just gonna throw their money in a pool and let it ride the wave? It’s interesting psychological behavior -- and I think if the trend towards indexing really, really takes off to very, very lofty percentages of total investing.

Yes -- you could see some pretty interesting dynamics happen. When companies are removed from indexes what will happen to their stocks, my goodness you know. Completely unrelated fundamental items could be catalyst for their movements -- so very interesting dynamics at play here.

Kris:

Yes, definitely -- so that concludes our discussion on indexing. Thanks and stay tuned for more updates.

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The Best Ideas Newsletter portfolio and Dividend Growth Newsletter portfolio are not real money portfolios. Results are hypothetical and do not represent actual trading.


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