The signs of excesses are everywhere. The distortion is different this time around because of its breadth. In the dotcom era, all the action was in growth stocks. In 2000, well over 90 percent of the assets in mutual funds were invested into growth funds. What makes this run-up different is all boats are rising. Passive investing results in the indiscriminate buying of all the stocks, both growth and value. One hint of the overvaluation: The average stock in the S&P rose to 2.5 times in 2017, compared with 1.6 times sales in 2000.
Flows have followed outperformance as passive funds outstripped active funds. Davis notes that passive’s blind, indiscriminate purchasing can’t help but distort prices in the most liquid cap-weighted index funds like the Standard and Poor’s 500 as they pour new investment dollars into the highest-flying stocks and less into stocks that are underperforming. This self-reinforcing pressure on cap-weighted indexes puts upward pressure on prices. In essence, it buys more of what has gone up and less of companies that have any short-term underperformance. It’s almost the inverse of buying low and selling high.
Brandes sees the indexing movement as being characterized by excessive attention to costs to exclusion of all else—including the discernment brought by well-conducted active managers. This extreme focus on costs has all the bearings of a bubble mania, because it focuses too strongly on one factor—in this case low fees. Is the notion that you get what you pay for not applicable to investing, or has the true cost not been seen yet?
These passive products don’t promise to maximize returns. They promise nothing more than to closely mirror the market index they represent. They offer investors the comfort of conformity. Thus, “the manager who produces market-like returns likely won’t get fired or feel foolish” or look bad before her board of directors or clients. Better to have slightly underperforming index returns “than tolerate occasional periods of significant short-term underperformance from a portfolio with the potential to significantly outperform over a long period.”
The cost of not looking bad is never looking good. And isn’t the willingness to go against conventional thinking the very essence of sustained outperformance?
Active managers charge much more than their passive counterparts, because they are trying to do more with investors’ money.
Academic research has helped increase awareness of the futility of the hot-hand argument. Burton Malkiel, Ken French and Jack Bogle have long supported the idea that hot hands rarely beat the market for any sustained period. Their statistics have been persuasive in convincing the investor that asset managers cannot possibly beat the benchmark. So why then pay an active manager anything?
The reason: Bad as active managers are at hitting the benchmark at present, the individual investors rank worse. And they need the services of an active manager to protect them from themselves, particularly in an investment world filled with shocks and extreme volatility. The investor needs a pilot that can chart a long-term course between the Scylla of fear and the Charybdis of greed for the investors’ benefit.
Proof that individual investors need protection from themselves comes from the DALBAR Quantitative Analysis of Investor Behavior study. Individual investors rarely spend more than four years in any fund or strategy. That means that they don’t stay put long enough to play out any legitimate investment strategy.
DALBAR reports in a special study that over the last 10 years the average equity fund investor has earned an annualized return of only 8.31 percent, as of September 30, 2018. The average actively managed equity fund manager earned 11.02 percent over the same 10-year span. The difference amounts to 2.71 percent per year or a 32 percent difference in return.