Systemic Risk from Passive Investing:

The active investment management industry has earned itself a terrible name. Two thirds of all equity mutual funds in the US underperform the S&P 500.  What is worse is that, as a group, investors in mutual funds underperform the funds themselves because of mistimed entries and exits.  Fees on actively managed funds including entry and exit loads are high. Their fees have made asset management companies and their star investment managers rich while delivering mediocre performances for investors. One is reminded of the title of a popular book about Wall Street called “Where are the customers’ yachts?”  When one looks at what is going on in the hedge fund industry, the situation is even more appalling. Hedge Funds on average have underperformed consistently and failed to deliver value despite charging egregiously high fees. No wonder then that there is a big backlash in the public pension space against allocations to hedge funds and a push toward passive investing at much lower costs.  

Warren Buffett in his letters to investors calls people in the investment management industry “helpers” who are out to take the wealthy “Gotrocks” family for a ride. He recommends that investors should fire (i.e. redeem) all their active managers and instead allocate a fixed amount periodically to a low cost index fund like Vanguard that replicates the S&P 500 index. It seems like the investing public is listening. Over the previous ten years, assets under management in actively managed mutual funds have declined as investors have shifted assets to passive funds like Vanguard and Exchange Traded Funds (ETFs). Interestingly this has put into motion two negative self fulfilling cycles. As more money heads into passive strategies, index stocks outperform non index stocks leading to further underperformance and consequent redemptions from active management. Also, as active managers become more obsessed with tracking error and benchmark underperformance, they start closet indexing their portfolios to reflect pseudo-index funds. With interest rates near zero and flows into equity markets continuing unabated, it appears like investors have discovered a new alchemy in passive investing.

It is important to stop for a moment and think about the staggering nature of the shift underway.This has very large consequences for investing and investors. If investing is all about flows and all about supply and demand of a particular security then the underlying and fundamentals do not matter. This would then be the anti-thesis of the fundamental value investing hypothesis proposed by Benjamin Graham that the market is a voting machine in the short term and a weighing machine in the long term.  

If there is any truth to Benjamin Graham’s hypothesis, the weighing machine will eventually overpower the voting machine. Given the size and duration of the passive investment trend, it is inevitable that equity indices and their linked passive investors will endure very long periods of underperformance. On the other hand, disciplined active investors who know what they are doing (a dwindling lot) will likely outperform the consensus for an extended period.