What happens when passive investing takes over the investing world?

What happens when passive investing takes over the investing world?

“Like most bubbles, the longer it goes on, the worse the crash will be.” – Michael Burry, ‘Big Short’ investor, who made millions after predicting the US housing crisis of 2008.

The boss of Scion Asset Management, who was portrayed by Christian Bale in the movie adaptation of Michael Lewis’ book “The Big Short”, is not afraid to make big controversial calls.  He just made another one on passive investing.

Burry’s thesis on passive investing goes something like this:

• The rise of passive investing tends to (and may continue to) distort stock prices. Why?  Because the actual valuation of the stock is not considered – money just flows into the index.
• Via passive investing, there is also money flowing into small companies. This further distorts the prices of these companies (much like factor-based investing might do; investing based on rules or “smart-beta” investing). 
• Passive investing can include derivatives – which can cause even more volatility.

To summarize Burry’s thoughts from this article:

“All those money managers market lower fees for indexed, passive products, but they are not fools — they make up for it in scale.”

Yikes.  Quite the shot.

So what happens when passive investing takes over the investing world?  What happens when the passive investing bubble pops? Will ardent followers of this investing approach be doomed?

I asked similar questions recently to Todd Schlanger, Canadian Senior Investment Strategist at Vanguard, since I wanted to see if there was any truth to Burry’s comments.

(For those that do not know…assets in passive investment strategies have been on the rise globally for decades now but have only recently gained momentum within Canada. Last year, for example, net cash flows into Canadian listed ETFs, which are mostly passive, outpaced active funds sales for the first time in ten years. Yet, despite this growth, widespread myths and misconceptions surrounding the decision to invest in an active or passive strategy remain common across the country.)

Vanguard, is one of the largest providers of active and passive strategies in the world with over $1.3 trillion (USD) in actively managed assets along with $4 trillion (USD) in passive strategies.

You can read my primer on passive investing and indexing on this page here.

Here is what I picked Todd’s brain about…

Todd, thanks for the time, very much appreciated!

Happy to do this Mark.

Let’s start with this – are you surprised by the rise of passive money management in recent years?  Why or why not?

Canada has been lagging other markets in its adoption of passive investment strategies, so from that standpoint, it’s not surprising to see some growth in that area. Ultimately, broad market passive investment strategies can be run at a lower cost than actively managed strategies, are well diversified and are reflective of the market conscience regarding how securities are weighted. So, they are a great starting place for asset allocation and tend to outperform higher-cost investment strategies.  

So that said, some investors are aware “fees matter” but don’t put their knowledge into practice.  What’s your elevator pitch to those investors who haven’t yet acted on the merits of passive investing?

There is no sense in caring about fees for fees’ sake.

Investors should care about lower fees because they are associated with better performance. It’s not even specific to just passive strategies. Research has shown that by focusing on active strategies with lower management fees, investors can improve their odds of outperforming in the long-run.

There is a lot of noise in the media about a pending recession.  That we are overdue.  A big correction is coming.  I recently had a post on my site about how to prepare for a market meltdown. 

Do you agree with these recommendations?  What else would you add?  

You make some great points in your article Mark.

If I had to nail it down to one thing, it would be discipline – which is crucial to an investment strategy because the markets are cyclical and past performance often does not repeat. That makes investing more difficult for people to understand because it works counter to how they shop for many other consumer goods.

As a best practice, revisiting your risk tolerance once a year is a great idea. By the time a market correction happens, it’s often too late to have that conversation as emotions are high, so we recommend advisors be proactive and talk to clients about the potential for bad times, during good times, and consistently prepare them for the possibility of market volatility. That can build trust in the relationship and helps the advisor to be a more effective circuit breaker for clients in choppy markets.

I believe there is case to be made that some active money management can work by owning the same top-stocks the big ETFs and funds own.  What are your thoughts on that strategy – to skim the top stocks held within Vanguard ETFs like VYM, VIG, VTI, VCN or other and own those companies directly?

The larger ETFs tend to be market-cap weighted, meaning they assign weights to companies in proportion to their weight in the market and in recent periods, a few large-cap technology companies have delivered strong returns and made up a large share of the markets overall return. So, it’s not surprising to see interest in overweighting large companies.

However, markets are cyclical and trends often reverse. For example, about 10-years ago as we were coming out of the global financial crisis (GFC), small-cap equities had outperformed significantly. At the time, the most common question was the opposite, should small-caps be overweight in my portfolio? In many ways, the performance of small-caps following GFC drove interest in alternatively weighted indices (smart-beta that you cited above) that assign higher weights to smaller companies.

As a best practice, it’s generally better to think long-term and not overreact to changes in market leadership.

Some investors are leery about investing at a market high – they feel it’s better to wait until equities fall lower in price.  What advice would you offer investors?  Why?

Timing the market is notoriously difficult.

Just look at what happened since the S&P 500 fell by over 50% in the global financial crisis. Within a couple years, it had increased by more than 100% and I can remember calls for investors to take risk off the table then and look what’s happen, the market is up by another 150%. If an investor were to miss out on those gains, there is very little you can do to make up for it. That’s where financial advice can help investors rebalance to make sure their risk posture is appropriate for a downturn that could happen when we least expect, as most things that change market direction in a significant way are unanticipated.

The behavior aspects of investing can’t be emphasized enough.

(Mark – I wrote about how to mind your investing behaviour gaps to deliver investing success here.)

Given that passive investing ultimately helps investor behaviour, what might happen if most investors eventually follow a passive investment strategy – with the investment industry collapse?  (Recall there was a lot of noise recently on this subject – that Michael Burry article caught some attention.)

First of all, passive investing has helped millions of investors, large and small, reach their investment goals and build additional wealth.

Yet, globally index funds make up only around 10% of investable securities. Even in U.S. equities where it has become a large share of fund and ETF assets under management, the passive investing share of the total market is a modest 15% of investable securities. 

Most of the criticism you have been hearing is targeted at the theoretical implications of its growth considering that active participants such as high-frequency traders, hedge funds, and individual investors determine market prices. 

If you look at the percentage of trading done by passive strategies in the U.S., it’s only around 1%, meaning active market participants account for 99% of trading.

So, due to the lower turnover of passive funds, they can account for a large share of fund and ETF AUM while active market participants still (due to the majority of trading) lead price discovery.

Ultimately for investors, is passive investing better than any active money management?  Why?

There is no universal case for active or passive, those are only labels.

In terms of things we can quantify, only low management fees and low turnover (a proxy for transaction costs) are associated with better performance.  That much is very clear.

The only difference is that with a broadly diversified passive strategy, you know what you are getting in advance, which is the market return minus a small cost. To be successful with active investing, you need to acquire a high degree of talent at a low cost, which creates a paradox.  At Vanguard, we do the latter pretty well due to our ownership structure, scale, and long-term relationships.

For individual investors, that don’t have our scalability and expertise, they need to be patient with their active strategy over time since short-term it will go in and out of favor.

Ultimately, I would encourage investors to consider a low cost, broad market-cap weighted passive strategy as the starting place for asset allocation and use then choose active strategies where you can solve the high-talent, low cost paradox – including the discipline required with that strategy over time.

What happens when passive investing takes over the investing world?

There are some guesses on the table, but we don’t really know the answer. Nobody does. 

I know when it comes to my portfolio, I plan on focusing to own a number of dividend paying stocks from Canada (for income generation), a few U.S. stocks (for income and growth), coupled with some low-cost U.S. listed ETFs to obtain both some distribution income but mostly long-term growth from my portfolio.

You can read about my dividend journey as we near financial independence here.

You can read about my low-cost ETF selections here.

I have no intention of changing my approach, becoming a full-on indexer or passive investor – but never say never to anything in life.

What do you make of the rise of passive investing?  What questions might you have for Todd?  Fire away!  Thanks for reading.