“As a discretionary asset manager I see high prices and high valuation as indicative of lower future returns and therefore I’ll try to find alternatives,” says Green, who used to work at Peter Thiel’s family office. “A cap-weighted index does the exact opposite. They don’t change their cash holdings and paradoxically they allocate more of the marginal capital to the most richly valued companies so it becomes a reinforcing mechanism toward inelasticity.”
In this line of thinking, it’s not that those distortions can never reverse, just that they are exacerbated by indexing. Another recent paper suggested that passive flows into the S&P 500 have disproportionately pumped up prices of its largest members, paving the way for smaller companies to eventually outperform.
Choueifaty, who founded asset management firm TOBAM nearly two decades ago, says that indexes give investors a false sense of security for precisely this reason.
“The market-cap weighted benchmark always allocates to what is already fashionable and already expensive,” he says. “Whenever you’re passive, you’re extremely far away from being neutral.”
Firms pitch market-cap weighted index funds to investors as a way to diversify away risks. The pitch goes that if you’re invested in 500 stocks, a couple of duds won’t hurt you. But to Choueifaty, seemingly neutral index funds are in reality crawling with harmful biases and distortions.
Take the S&P 500. The top five members, all technology names, are weighted as heavily as the bottom 350 companies. Sectors become dominant precisely when they’re at their most expensive. For long-term investors, that’s a disaster, Choueifaty says.
If you accept the premise that the trillions flooding benchmarks must be having some impact on market plumbing, it becomes easier to draw a line to distortions all over markets in 2021. Think meme-stock madness, stock volatility through the pandemic and tech giants trading at hundreds of times earnings.
Yet that risks simplifying complex and interlocking forces behind modern markets. That’s why Fraser Jenkins now says that even though indexing has likely made stocks increasingly move as one, the threat to capitalism he flagged in 2016 is still not imminent.
“Back then, I was wondering if there’s a limit that was imposed by a breakdown in the efficient allocation of capital or from correlations jumping and going too high,” he says. “I think any limit from those sources is just far, far off.”
That said, a stress test for the benchmarking era may be coming if higher inflation undermines balanced portfolios, according to the Bernstein quant.
“If the risk for things like 60/40 goes up because equities and bonds don’t diversify the same way, then that’s a limit to passive investing and demands an active response,” he says.
So does that mean the portion of total assets held by passive would slow in this doomsday scenario? Unlikely.
“It just goes up,” Fraser Jenkins says.
This article was provided by Bloomberg News.