There are a couple of things I’ve been thinking about over the last year or so and a great interview last Friday with Michael Green on Real Vision TV helped me piece it all together. Quick side note – for anyone serious about following the investment markets, Real Vision is absolutely the best source for high quality information. This post is going to talk about some of the bigger shifts we’re seeing in the investment world, namely the move from active funds to “passive” index funds. I use very few funds for my clients to begin with so I’m not necessarily a proponent of one over the other. Quite frankly, I think the whole debate is missing a lot of key points and both styles of funds can have a place in portfolios, with each one proving to be more beneficial at different points in the market cycle. I will say though that I believe a properly managed portfolio should always outperform an automated, model-based portfolio over the long run, but that’s another story.
There has been a massive movement of money away from active management toward passive index funds. This has been an ongoing debate for probably the last 40 years and you tend to see the same mentality play out every cycle. The stock market rises, active managers begin to underperform on the way up, investors wonder why they are paying higher fees/expenses for underperformance and they flood into index funds. Then the market falls, active managers outperform and investors start to come back, but not as much as they used to have invested with active managers because they slowly start to believe that indexation is the best way to invest – fortunately they held on to some of their actively managed funds during the down cycle but now they should just load up on more index funds. So let’s break down why this happens.
Equity Fund Flows – Mutual Funds vs ETFs
(source: Yardeni Research)
An index fund is simply a fund that replicates a well-known market index while trying to keep expenses to a minimum. It’s a way of saying “I don’t want to do any research or need to track specific investments so just put me in the broad market and I’ll accept what the index does.” In order to minimize a tracking error, index funds are essentially 100% invested. For any new investment dollars that come in, all of the money is spread across all stocks in the index based upon the index weights. And all stocks are sold for any money being redeemed from the fund. This is a price-insensitive strategy because there is essentially no thought process that goes into it and zero consideration for price or valuation. A computer in the back ground does all of the buy and sell orders based on the amount of money coming into or leaving the fund each day.
On the other hand, an actively managed fund is run by a manager/investment team that is doing research specifically choosing their favorite investment ideas and ideally buying at a low price/valuation. Managed funds tend to hold a little cash so they have some dry powder in case a stock they’ve been following drops to an attractive entry price and also to give themselves a cushion against investor redemptions from the fund so they are not forced to sell some of their positions at an unfavorable time/price. Most funds tend to carry a cash balance around 5%. The simple fact of being only 95% invested means they’re facing an uphill battle to outperform a corresponding benchmark index during a strong up market. However, this cash becomes extremely valuable in a falling market (to pick up great bargains) which helps actively manage funds outperform during bad years.
Conceptually, this simple difference of being 100% invested versus holding a little cash means that an investor should want most if not all of their money being actively managed at the top of the market cycle but history tends to show the exact opposite occurs. Many investors unfortunately make investment decisions looking in the rearview mirror by basing their decisions on past performance data. So after years of index funds looking like the greatest thing since sliced bread and active managers underperforming, they wonder why they’re paying higher fees and move more money into index funds at exactly the wrong time. We go from “buy and hold investing is dead” in 2009/2010 to full-out indexation and Robo-advisors in 2015-2017. Now, it’s extremely difficult to know when we’re at the top of a cycle, but conceptually speaking, the longer a bull market runs, the more an investor should start to favor active management.
What’s interesting is that this growing movement toward indexation has exacerbated the ups and downs of the stock market. Here’s why: the better the performance of an index, the more money it attracts from actively managed funds. By shifting dollars from an actively manage fund that was only 95% invested into an index fund that is 100% invested, the investor is increasing his allocation to stocks without realizing it, which essentially puts more money into the market through a price insensitive strategy which ultimately benefits the largest components of the index, thus driving the index even higher. At the same time, by reducing the amount of money in actively manage funds, the collective marketplace is adding additional selling pressure on what are probably undervalued stocks AND essentially eliminating a very strong shock absorber that it once had. Remember that actively manage funds tend to hold a chunk of cash which they utilize for opportunistic buying when stocks drop. With less money being managed each year by active managers, there’s less cash available to act as a bid as stocks are falling. And on top of it all, it has been proven time and time again that retail investors tend to buy high from the excitement of a rising market but panic and sell low during falling markets. So with so much hot money now in index funds, what is going to slow things down if something starts to spook index investors? Both of the mini flash crashes in the last 7 years saw very odd orders transact way below the market price in balance. Most of these have been attributed to the price insensitive nature of index funds facing redemptions, forced to sell with no bids close by.
Let’s expand this a little further: Early last year the Department of Labor passed a new Fiduciary Rule for the investment industry. Without getting into the details, it has created new requirements for advisors of retirement plans/accounts. It basically had a net effect of strongly encouraging many retirement plan advisors to use low cost index funds over actively managed funds in a systematic robo-advisory approach since they can fall-back on data by showing a quantifiable difference of a lower expense ratio and investment models based on historical data. The deadline to comply with this new Fiduciary Rule is next month. And guess who were two of the largest consultants for the Department of Labor in creating this new law…? Vanguard and Blackrock (owner of iShares ETF’s). This has helped shift an additional $1 trillion toward index funds, the lion’s share of which has obviously gone to Vanguard and Blackrock, but I digress. Just year to date in 2017, global stocks have pulled in a massive $82.4 billion, with $106.9 billion going to ETFs while $24.5 billion has been pulled from mutual funds.
I think is a big reason why the US stock market has been so resilient over the last year and why the best performing stocks continue to be the largest components of the indexes.
One more thing: There is over $25 trillion in US retirement accounts, most of which is held by Baby Boomers. April 1 is the deadline for Required Minimum Distributions (RMDs) for the oldest of the baby boomer generation (people born in 1946). Moving forward, they’re going to be forced to withdraw roughly 4% (per year) and the percentage increases every year as they age. This year it’s just those born in 1946 (plus everyone older than that). Next year, it’s the people born in 1946 and 1947. The year after: 1946, 1947 and 1948. This is how demographics plays such a key role in investment markets. It’s a glacial shift but is an inevitable headwind as investments are forced to be sold. Studies show that about 85% of RMDs are spent which means very little is ultimately reinvested. With such a large movement toward index funds, which has aided markets as indiscriminate buying, one has to wonder if we could see the slow reverse over the next decade (i.e. price-insensitive selling and an underperformance by the largest components of the indexes). Interestingly, since withdrawals for traditional retirement accounts are fully taxable, the government is about to see an increase in much needed tax revenue.
It will be interesting to see if fund flows slow down after this month, coinciding with both RMD’s and the transition to ETFs from the DOL’s Fiduciary Rule. Big shifts like this help to explain much of the difference in performance between various asset classes. This is no different from the late 90’s when Growth stocks crushed Value, only to see it completely reverse course once the market topped and began to fall. I think we’ll likely see the largest mega cap stocks continue to benefit disproportionately as long as the movement to index funds continues but this is certainly a trend worth following.
-Nick