Passive Investing Bubble?
I heard an interesting theory recently from a guy named Mike Green that as we move into passive investing it's creating sort of a self fulfilling bubble, which is pushing valuations up and can largely explain active investing underperformance recently.
His argument is basically that active investing is the world's most simple algorithm, which basically gives me money and I will buy stocks, redeem money and I will sell stocks, and that these funds do not care what price they are paying or about fundamentals, all that matters is if people are giving them money. So, as active investing gets larger, the fundamentals of a company are beginning to matter less, and if driven to the extreme all that will drive stock prices is it the net flows of ETFs basically. His theory is that this is creating and will continue to create more volatility in the market and that if carried to the extreme where 99%+ of the market was passive valuations could increase 50x, which obviously most likely will never happen. He does a much better job of explaining it than I do so if anybody wants to hear more about it I highly encourage you to look him up, he has been on a bunch of podcasts recently and he seems like a super-intelligent guy.
I know Michael Burry came out with some similar comments in a letter to Bloomberg late last year too. I just wanted to get a discussion going from some more experienced people on this forum on how people think about this, how they think this has impacted valuations and returns of active managers recently and how people see this eventually ending. My general feeling is that if markets begin to turn again and retail investors start pulling money from index funds it could end very badly, but would love to see some discussion on the topic.
This would be a good one for you to read along the same lines:
https://www.oaktreecapital.com/docs/default-source/memos/investing-with…;
Good news boys. If this guy is right then when this passive investing bubble will pop, fees will go up for active management and returns will become easier to generate for us discretionary traders, and all of this will result in us taking home much fatter checks. #mikegreenforprez
This would also mean that hundreds of millions of people would lose most of their 401k right.
Yeah but we will be paid much more than what we are right now.
The argument that passive investing can or will distort individual stock price discovery doesn't hold any weight.
However I agree that it leads to broader volatility swings in the market, largely by the far higher take up of these products by unsophisticated investors who tend to fall for all the typical psychological pitfalls and herd mentality.
As for a bubble, I think that is far more due to central bank policies and general asset inflation (growth premium) than passive investing. Passive investing is another vehicle for investors nothing more.
How do you disagree with it affecting price discovery?
Seems like that is the strongest point against it and is fairly clear. The whole idea of EMH is that investors actively digest all available information to determine the price of assets via a competitive market, if no one is using the information or less people are using the information, isn’t the market obviously less efficient/prices less accurate?
the fundamental assumptions of weak, semi-strong, and strong EMH are premised on active investors with no transaction costs always regulating prices. Also requires homogenous ideas of value for investors, ie all place the same value on an asset with x expected return and y volatility.
seems like index funds by default make markets less efficient and ruin price discovery by violating 2/3 assumptions of EMH.
There will always be alpha. The question you should ask is how to capitalize on this passive investing bubble?
Index rebalances become more meaningful as passive gains share. Predict those flows and you got yourself a profitable strategy.
I'm primarily a passive investor (i.e. majority of my investments are in $VOO and $VT) and do worry it's becoming a bubble. That said, I also think if your time horizon is long enough, there's no need to panic sell just because it's a bubble and affecting price discovery.
I'm not an experienced or super successful investor by any means, but I feel like money tends to follow the best risk-adjusted return until that space gets bid up, and the bubble either pops, or it normalizes, which causes people to get bored and chase the next vehicle that provides high risk-adjusted return. A lot of Millennials and Zoomers have figured out that if we don't want to buy a home or can't afford the down payment on a home, investing passively in a broad index gives you just as good or better return with less capital commitment. As such, a ton of money is flowing into $SPY/$VOO, and since those names are overweight tech, I think that consequently the FAANG/TSLAs of the world that have been successful the last decade have disproportionately continued their rise the past few years.
My prediction on the end game is that, rather than seeing a gigantic pop in $VOO, we'll instead see lower future returns, people will get bored of the future 5% returns on $VOO when less sexy industries that weren't bid up so high start generating outsized returns + paying high dividends. Therefore, we'll instead see the currently overweight tech names in $VOO represent less of the index as a whole and the overall return of $VOO will slow for a long period of time till the index re-sorts it's allocations and as money flows back to active investors who took a more value-based approach.
I'd argue, however, that the excess liquidity by governments has had a far bigger impact on obscuring price discovery than passive investing has.
Active investing has mostly been terrible for clients and prospective clients have finally--after decades of academics and otherwise pointing this out--seen the light.
I'm not suggesting anything for the market at large. I'm suggesting that individuals would be foolish to put a significant portion of their assets with active management, who, for decades upon decades, net of fees, have consistently underperformed the market. Picking the few active managers who will consistently beat the market is as difficult as picking a company that will consistently beat the market, so if you want to actively invest you might as well just buy stocks in companies you understand and like.