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.
I think the shift is partially (as you said) progressing from active to passive investing, but another big factor is the shift away from fundamentals/technicals to basic supply/demand...the more popular a company’s brand name or product the more buying will happen. This may be due to high volume HFTs and others following retail investors’ sentiment (think Citadel). There are some pretty significant recent examples of this. Interested to hear more on this 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…;
Thanks for this, have read all Howard Marks books and am subscribed to his memos but haven't seen this one, will give it a read.
Great read. Thanks for linking it.
This is an extremely important topic and Mike Green is spot on. This is partly why FAAMG have and continue to outperform. It’s also why value funds are struggling and see redemptions left right and centre (same as 1999). I think the issue is that the ETF creators have very strong political muscle and influence to the extent that media will never focus on this issue. Icahn has also spoken about this before, worth reading.
Do you see this reversing anytime soon?
I am definitely not qualified to answer but I don’t see it changing soon. Penetration of passive in public equities is still <40% and the younger generations (including me) overwhelmingly allocate to passive vehicles rather than active. I see increasing penetration of private capital and passive as the two secular trends which will define the next decade. Some info here: https://www.morganstanley.com/im/publication/insights/articles/articles…
Just wait for the market regime change
Elaborate?
It's nice when you can ride Vantage ETF at 20bps fee as long as indexes have been going up overall for the past decade. When the indexes tank (it's not a yes/no question, it's a when question), are ppl going to wake up to the fact that active investing (well, if they are truly good) can provide downside protection?
Index funds / ETFs buy names in the indexes regardless of fundamental or prices paid.
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.
Imo when I hear people say this they are looking for excuses for bad returns and a story for why their bad returns mean they are (ironically) doing a good job.
if you think this then why not figure out how to take advantage of these distortions?
active management underperforms and destroys value on average. How can passive management be a bubble if this is true?
Do some research, this guy is not a stock picker, he runs a macro fund. His fund has take advantage of this, they are basically betting on volatility by putting on straddles on the market, so he gets paid out on increased volatility in the markets. He is 100% taking advantage of these distortions.
You’re correct but that is partially due to LP behaviour (allocating to whatever worked rather than what will work). The market is zero sum so by definition the majority of alpha will go to select participants and most will underperform. Just bc the average underperforms doesn’t mean active management is dead (which is not what you said anyway). You should just strive to be top quartile
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.
And to make matters worse the fed believes in EMH so they let the market tell them what to do. "We lowered interest rates and the market went up, the market is perfectly efficient, so that was the right decision." I worry something is going to happen in the next year or two that is going to crash the market again, but the fed won't have any ammunition like they did in March, this liquidity bubble can't last forever. I think the sharp downturn in March was also partially due to passive. Usually value/fundamental guys will see prices are ridiculously low and start buying when that happens, which sort of puts a floor on things, but those guys are being pushed out of the market recently and passive guys aren't doing any more buying during a bear market or a bull market really, most just put in their monthly allocation no matter what's happening. As to what could pop the bubble, I think a wave of corporate bankruptcies is likely, There was an article in the WSJ this morning talking about how PE is just piling on debt on companies that probably can't handle it to pay themselves dividends. Money has been so easy this year, which wasn't the case back in 08/09. I just have no idea how long that could take to play out, probably could take years, but I have no idea.
There are some studies that have shown ETFs lag the cash index (cash futures for eg) and intraday underlying cash movements. From what I've seen that is also how market makers maintain liquidity in the etf by using the cash index as the arb instrument.
Why is this the case? Well my opinion (can't find a paper on this) is that sophisticated market participants generally transact in the underlying assets - whether that is futures, stocks, derivatives, etc. and etfs are largely a vehicle for people who can't easily transact in these other items.
This does break down when liquidity in the underlying is too low. Some bond etfs have had severe dislocations because some of the underlyings aren't liquid enough.
This is all good news for sophisticated market participants as it is another source of alpha (arbing etfs and underlying or cash indices) and this is why etfs lag and why they are not a driver of price discovery. So while I agree they are a source of inefficiency this is pretty much an opportunity for others to make a little alpha and keep the inefficiency to a minimum.
The very existence and recent growth of index rebal desks shows how wrong you are
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.
So is fundamental analysis just slowly dying? It doesn’t seem like those who perform it generally get rewarded lately.
No, it just means that previously fundamentals may have played a larger role in governing asset prices but now, in the modern-day, has decreased relatively. To what exact extent is not important. What is important is taking into account the new forces driving asset pricing, in this case, index rebalances as a result of passive investing gain shares and its implications.
Fundamentals will always be around, albeit with alpha becoming more concentrated in certain industries in my view.
@AreteP
Agree. The underlying principle behind this is largely fundamental-driven in my view. Indices re-weight based on market cap and liquidity mostly, and predicting these flows is predicting the future winners and losers.
The 5-10x’ers tend to be SMID’ish at the start and then enter indices as they grow.
Passive investing and active investing are not separate entities of right and wrong. They are merely neutral participants with their own set of market behavior. A. The aforementioned “passive bubble” is a feature and a plausible scenario when any investors are present. The core reason for the observations is driven by the same human behavior and the topic could easily be an “active investing bubble” if we were looking at another time frame or a “fill in your blank bubbles.”
Bubbles are a feature, not a bug, and being aware of the governing forces of a market that derive these anomalies yields extraordinary returns. Disputing what school of thought is right, e.g, value versus growth, emf, etc., is a practice in futility in regards to generating alpha.
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.
The logic behind this response is simple and makes a lot of sense. Thanks for this.
Cap weighted indexes do well in bull markets and poorly in bear markets. ETFs are just an interesting footnote but this has been the case for a long time. We are 12 years into a bull market. The prior market could be considered “neutral” as all gains from 2001-2007 were given up in 2008. My point is, nobody has seen a real bull market in 20 years and now that it’s here everyone is real confused...
That said the race to the bottom with fees are real, and I’m not sure active funds can compete with index funds given the dramatic fee difference. I think algo-based ETFs are here to stay. Active managers will do better to move their abilities to private markets where the mispricing is more dramatic.
Matt Levine has talked about this before in some of his newsletters.
One argument he makes is like this:
If all capital flows into passive, index funds, ETFs or whatever, people start to care less about the fundamentals about companies --- which is exactly what OP talks about in this thread.
Meanwhile, a LOT of companies would enjoy the exact same set of big shareholders: BlakcRock, Vanguard, State Street, Morgan Stanley, Alphabet, you name it. To a certain point, those shareholders do not care WHICH company is doing a good job, as long as the COHORT is doing a great job. Company A's stock price goes to 0 from $10/share? No problem, as long as Company B's market cap increase somehow offsets this and attracts new equity. They mght even reap in more money.
If passive investing dominates the market, one day people would stop caring about the actual businesses companies are doing, which is kinda insane, but not impossible, considering idiots making random trades on Robinhood (including myself), and talking about company fundamentals everyday after dinner while they are hammered.
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.
So do you suggest everything goes passive? Passive investors are essentially freeloading off active investors, so if active investors are removed from the market imagine what that would look like, it just wouldn’t work. There will always be a place for good active investors who outperform.
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.
While passive investment strategies do account for a lot and a growing percentage of the market, in my opinion, price discovery is lightly effected by it. Prices are found through supply and demand levels in trading. By nature, passive investing accounts for only a small amount of trades while active investing accounts for almost all trading.
What I do think may be a problem is the lack of true financial analysis done by active managers. This could be due to the rise of retail traders.
The switch from passive to active investing only has the potential for meaningful impact on the relative valuations of stocks, not the absolute valuation of the market. Most of the exodus from active was in the long only category (e.g. mutual funds), and assets under management for long short neutral products have largely grown or stayed the same. An outflow from a long only mutual fund benchmarked to the S&P 500 and a corresponding inflow to a S&P 500 ETF doesn't really change the valuation of the S&P 500. It just increases / reduces the valuations of stocks that the mutual fund was underweight / overweight relative to market cap weights. All this really means is that mutual funds now have less control of relative pricing of stocks, and more of that burden falls on hedge funds.
The valuation of the market as a whole (holdings earnings and risk constant) is mostly a function of wealth in the world relative to financial assets, and investors' preferences for cash vs. financial assets. Central banks around the world (not passive investing) are responsible for today's valuations, as their money printing created strong preferences for assets over cash.
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