At a recent International Investment Conference in Cape Town, an active manager rather unkindly referred to passive investors as “zombie” investors; in the sense that passive investors who invest in an index, based in some way on the market capitalisation of the underlying shares, were investing regardless of the prices or the fundamentals of the underlying stocks. The terms “passive”, “index” or “ETF” investors are also used to describe investors who invest in an index according to the underlying market capitalisation of the index.
A quick look at the S&P500 index, a popular passive base for investing in US stocks, shows how a US$100 investment would be invested in a passive portfolio or ETF based on the S&P500. The first US$10 will be invested in just three shares, with the second US$10 encompassing another seven shares. So, the first US$20 will have been spent on only ten shares of the total 500 within the Index.
If we extend that out a bit further, then half the US$100 investment will be in just 50 shares of the total 500 within the Index, leaving 450 shares to take care of the other half. There is nothing wrong with that, surely? The investor will have a heavy exposure to the largest shares and a lighter exposure to the medium-sized stocks.
It is all good until one examines the actual flows that are going into those passive investments. Both of the below charts, recently shared in the Financial Times, show a tidal wave of investor flows recently being invested in passive funds or ETF’s. Simple Economics 101 tells us that excess demand for any goods has the effect of pushing the price up from an equilibrium level until demand peters out at a new equilibrium price.
The danger of the flows shown in the chart is that these are not flows from active managers who are examining the fundamentals of each of the shares in the S&P500 and actively bidding up the price of US stocks because their fundamentals demand a higher price. These are flows from investors who are insensitive to price and buying simply because the stock is in the Index.
Moreover, the higher the price of the stock is bid, the higher its market capitalisation, the bigger proportion it has in the Index, and the more the passive investor will demand of it.
This investor behaviour is common in late cycle bull markets when it appears as though momentum is the investor’s friend.
Jack Bogle, the founder of Vanguard, has referred to the recent flow of funds into index funds as “more like a tsunami…” referring to the wreckage that such a tidal wave shift can wreak, both on the way in and on the way out.
At MitonOptimal, we are active investors on behalf of our clients and believe strongly in the ability of some managers to outperform markets at certain times. However, we do use index funds judiciously where we need to gain access to markets cheaply and quickly. They are ideal investments for exposure to the general movement of the market (known as the ‘beta’) rather than the performance of a particular basket of shares.
Many of our client solutions will have some exposure to passive investing, either for temporary purposes or long-term access to beta.
We also keep a close eye on the effect of investor flows, especially in late cycles, to be wary of the damage done when the tide caused by the tsunami goes out!
“Zombie” Investing - Right or Wrong?
