If something cannot go on forever, well then, it will eventually stop. So said economist Herbert Stein when he made this obvious but insightful observation. Trees do not grow to the sky, and matters that are truly unsustainable eventually come to an end.
The most recent example of something that can’t go on forever has been the inflows into low-cost, passive index funds, primarily to the detriment of higher-cost, actively managed funds. As the Wall Street Journal reported:
For the first six months of 2018 the amount of money going into all U.S. passive mutual funds and exchange-traded funds was down 44 percent from the same period a year earlier.
The decade after the financial crisis saw rivers of money gushing into the three biggest indexers — Vanguard Group, BlackRock Inc. and State Street Corp. These firms now manage almost $15 trillion in equities and fixed-income funds. All three are many times larger than they were in the mid-2000s.
During the fat part of the inflows, many fearful explanations were cited as a reason. Some were simply silly: indexing was Marxist, or nonprofit or Socialist, a bubble soon to burst, dangerous to the economy, and so on. Others were less histrionic, but just as misinformed and wrong.
A more factual explanation for the shift toward indexing is: 1) Changing business models in the money-management business with the move away from commission brokerage accounts and toward fee-based advisory; 2) investors were not getting the promised gains from many active managers, especially hedge funds and other alternative investments; 3) investors became disillusioned by a series of accounting frauds, analyst scandals, scams and Ponzi schemes in the 2000s; 4) a sense that markets were rigged against the little guy sent them looking for other options; 5) the broad acceptance of behavioral economics led many people to recognize that they lack the skills and temperament to actively manage their own money; and 6) repeated crashes and volatility in equities, commodities and housing finally exhausted the patience of a generation of investors.
There are many more reasons, but those intellectually and mathematically supportable explanations suffice for the purposes of today’s discussion on sustainable trends.
Now that the unsustainable is no longer being sustained, we already see similarly misguided explanations for the flow slowdown.
Yes, the inflow slowdown was correlated with a period of market swings tied to concern about trade wars and rising interest rates. But what about all of the prior market swings? We have had flash crashes, nuclear saber-rattling, special prosecutors, surprising election results here and abroad, even a downgrade of the U.S.’s credit rating, none of which slowed inflows. Finding a correlation, then implying that is the causation, is simply sloppy reasoning.
Nor are there good reasons to think that a reduction of inflows into cheap indexers represents — as some seem to think it does — a test of investors’ comfort with passively managed funds.