A SLOW AUGUST; PASSIVE TREND STEAMS AHEAD

 

Our favorite topic (passively managed index fund investing) was much in the news. Our favorite headline of the month, from Sanford C. Bernstein & Co. strategist Inigo Fraser-Jenkins: The Silent Road to Serfdom: Why Passive Investing Is Worse than Marxism. That grabs your attention!

 

We’ll look at what the fuss is all about after a quick review of August numbers.

 

 

GLOBAL STOCKS: For the month, global markets returned a paltry 0.39% (MSCI ACWI) following July’s broad 4.34% gain. It was also another sub-par month for the U.S., which posted a 0.26% return (Russell 3000). Global markets excluding the U.S. weren’t much better, returning 0.65% (MSCI ACWI x-US). The 8.01% YTD gain posted by the broad-market U.S. index helped global markets, which were up 6.39% YTD but only 4.95% excluding the U.S.

 

US STOCKS: For August, the S&P 500 declined slightly after five months of gains (12.49% cumulatively, falling 0.12%, but up 0.14% with dividends). The index traded in one of its narrowest ranges of any month in history. From the low of 1,829.08 on 11-February 2016, the S&P 500 has climbed an impressive 18.79%, with this month’s mild decline the only pullback. It was up 6.21% YTD and 7.82% with dividends, with an annualized rate of 9.443% and 11.92%, respectively.

 

The Dow again was the worst performer of the four key US indices in August, as it posted a 0.17% decline. It was also the worst among key US indices for the three-month period (up 3.45%) and YTD (up 5.60%).

 

The S&P MidCap 400 posted a 0.34% gain in August. It was the index’s seventh monthly gain, after a rough start in January (off 5.78%), leaving it up 11.88% YTD.

 

The S&P SmallCap 600 again did the best for the month, up 1.22% in August, after being up 5.03% in July. It posted its seventh monthly gain for a cumulative 19.54% following January’s 6.22% decline. YTD the S&P Small Cap is up 12.11% with a one-year return of 11.59%; both numbers top the four key US indices.

 

FOREIGN STOCKS: Emerging markets (MSCI EM Large Cap) again did better than developed markets, adding 2.52% in August. Developed markets excluding the U.S. were up 0.09%. 

 

FIXED INCOME: Barclays US Aggregate Bond Index fell 0.11% in August, bringing YTD returns for the index to 5.86%. Barclays US Tips Index declined 0.45%, reducing YTD returns to 6.68%. Barclays Muni Bond Index returned a slight 0.13%, with YTD returns of 4.54%. The Barclays High Yield Composite Bond Index did the best for the month among major categories, finishing up 2.03% and an incredible 13.70% YTD. The yield on the 10-year Treasury note rose to finish at 1.58%. 

 

 

Since the global financial crisis of 2008 we’ve seen a massive shift of funds from expensive, actively managed funds to inexpensive index funds and other passively managed investments. Private as well as institutional investors, many of whom got burned in the financial meltdown, have led this exodus. 

 

According to figures compiled by Morningstar for the Financial Times, passive funds today account for 33% of all mutual fund assets, up from 25% just three years ago. 

 

The reasons for this shift should be obvious. Actively managed funds are expensive, unreliable performers, and most active fund managers have a dismal long-term record despite the occasional glowing year. When investors pay for outperforming the market, the real metric is above-average returns over multiple periods of time. Repeated outperformance is the only proven way to separate investment manager skill from luck.  

 

According to the latest S&P Persistence Scorecard, of 641 domestic equity funds that were in the top quartile in March 2014, only 7.33% managed to stay in the top quartile at the end of March 2016. That’s a nearly 93% failure rate if staying on top for two years is your goal. 

 

Over the same two-year period, only 8.5% of the large-cap funds, 3.26% of the mid-cap funds, and 0.68% of the small-cap funds remained in the top quartile. You can do the failure-rate math. 

 

It gets worse as the timeline is extended. Over five years, only 0.78% of large-cap funds and zero mid-cap or small-cap funds remained in the top quartile. That’s a 99% and 100% failure rate, respectively, for active fund managers and those who pay them for outperformance.

 

Little wonder investors are moving their money. If they needed more encouragement, the volatile start to 2016 was a nightmare for the pros in active money management. According to Bank of America Merrill Lynch, only 15% of large cap mutual funds have outperformed the Russell 1000 through August 2016. That would be an 85% failure rate.

 

 

One of the big arguments against passive investing is that it could get so big that we lose the active investors who help set asset prices through research and by uncovering new information. This argument is intensifying in the financial press. It goes something like this: if all stocks were held passively, the market as we know it would cease to function because price discovery would cease. (Price discovery = the process of determining an asset’s price through the interaction of buyers and sellers.) This argument is used to justify the existence of active managers, even when they lose money.

 

As more and more investors pursue passive investment strategies, at what point will market efficiency break down? Is this a practical concern? Renowned economists Eugene Fama and Ken French addressed these questions at length in "Disagreement, Tastes, and Asset Prices" (Journal of Financial Economics 2007) and in their online forum. They say the answer depends to some extent on who turns passive. “If misinformed and uninformed active investors (who make prices less efficient) turn passive, the efficiency of prices improves. If some informed active investors turn passive, prices tend to become less efficient. But the effect can be small if there is sufficient competition among remaining informed active investors. The answer also depends on the costs of uncovering and evaluating relevant knowable information. If the costs are low, then not much active investing is needed to get efficient prices.” Their conclusion: it may take only 1% of active investors in a world of 99% passive investors to set prices and allocate capital efficiently.

 

Former Vanguard CEO John Bogle guesses that at least 90% of the active management industry could “disappear and the markets would remain highly efficient” in terms of information. That’s largely because index funds trade so much less often than actively managed funds. On an average day, only 5% to 10% of total trading volume comes from index funds, according to a Vanguard spokesman. That leaves plenty of room for active funds to set prices.

 

While active management certainly has been losing ground—and active managers are clearly on the defensive in the financial press—the art of stock-picking is alive and well. Backed by increasingly sophisticated big data, active managers play an important role in determining security prices, which in turn determine how capital is allocated. The competition for information is what keeps markets in equilibrium and prices efficient. Passive investing wouldn’t be possible without the work of active managers. To succeed, passive needs active and vice-versa. Investor preferences may come and go, but it’s safe to bet that in free markets, competitive market forces will ensure market inefficiency is minimized. 

 

Clearly the trend to indexing and passive investing in general is a huge threat to the active management industry. If all investing were to go passive, we’d have no active managers, no clients for research boutiques to sell their research to, and far fewer highly paid analysts and brokers. All of which explains why the active management industry is railing against the dangers of passive investing, calling it everything from “dumb money” that creates “significant risks” to “worse than Marxism.”  

  

For our money, passive and index investing is the prudent way to go. Passive funds offer many advantages, including a range of low cost opportunities to spread risk across markets, greater transparency, and added reliability in terms of capturing the reward for risk that markets offer over the long-term. Stay focused on your goals, remain diversified, evaluate your portfolio from time to time, and let the markets work for you. Don’t be worried by the amount of money flowing out of high-priced active investment firms, and tune out the alarming rhetoric about “too many passive investors,” even as the trend accelerates.