Since the 2008-2009 implosion, there has been a huge influx of funds into passive index strategies. In a recent interview with Welling on Wall St., Jack Bogle, who pioneered index funds at Vanguard in the mid-1970s, stated that “about $800 billion has gone out of actively managed funds, and about $1.2 trillion has gone into index funds” over the past six or seven years. “That is, roughly, a $2 trillion swing in investor preferences.” I attribute part of this shift to a response by investors that were badly burned during the financial crisis.
As a result of miserable performance by some brokers, advisors, or famous fund managers, investors chose to disintermediate with the same low-cost generic products that some investors have turned to after previous market collapses. This disintermediation has accelerated following market declines over the past four decades. (I do not think it was a coincidence that Bogle started his first index fund in 1975, after the near-40% decline in the market from 1973-1974.)
As the market is cyclical, indexation has performed well in a bull trending market, especially one that has been provided massive liquidity by the Federal Reserve. However, I foresee some headwinds forming for the index fund investor.
As passive index funds and exchange-traded funds (ETFs) continue to grow in scale, performance may suffer from the law of “large numbers.” In fact, Vanguard is the top institutional holder in nine of the top ten constituents of the S&P 500. If everyone were to invest in index funds, who will be the marginal buyer? I believe the “large number” constraint, which has plagued active managers throughout history, will soon be a headwind for passive investors. Additionally, the liquidity that had helped stimulate the market is rapidly turning into volatility. In other words, what was a straight road is becoming an increasingly winding road for market participants. Passive investing lacks disciplined risk management.
Index investing, by definition, is market-cap weighted. Essentially, there is a momentum bias, which is akin to the classic case of buying high and selling low, with no differentiation to the quality of a company within the context of price. I define quality as a free cash flow generating business with recurring visible revenues, and a management team that maintains a shareholder friendly capital allocation policy. However, if an S&P 500 company were to shrink its float (by repurchasing stock and perhaps making the stock more attractive in my view), they may be penalized by the market cap weighting and free-float methodology of index funds.
When such inefficiency exists, I relish the opportunity to deploy capital and maintain my risk management discipline. The popularity of index funds reminds me of the Nifty Fifty (or “one decision”) stocks of the early 1970s -- at some point expectations become unrealistic. Over time, the experienced fundamental active investor has the ability to outperform the generic passive investment philosophy.
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