Regular readers of Cuffelinks know we admire the client memos from Howard Marks, and in the past, he has given us permission to publish his institutional presentation material.
In recent memos, Marks has focussed on macro developments and markets, but this week he addressed three new themes that may reduce the role of people in investing:
- Index and other passive investing
- Quantitative and algorithmic investing
- Artificial intelligence and machine learning.
Marks admits he is not an expert in 2 and 3, and readers can check his latest memo (18 pages) for more details. We will focus on his thoughts on index investing here, and we have reproduced his short summary at the end.
Distinction between index and passive investing
Marks notes that index investing started when analysis showed most fund managers were not beating the market benchmarks. Vanguard's Jack Bogle launched the first widely-available index fund in 1975 with low fees and a replication of what became the S&P 500 index. Marks says:
"The merits of index investing are obvious: vastly reduced management fees, minimal trading and related market impact and expenses, and the avoidance of human error. Thus index investing is a “can’t lose” strategy: you can’t fail to keep up with the index. Of course it’s also a “can’t win” strategy, since you also can’t beat the index (the two tend to go together)."
The investment of money into index funds was slow at first, but by 2000 comprised about 12% of retail US stock fund assets, growing to 24% in 2010 and about 42% in 2017. Institutions were slower to adopt but are estimated to place about 20% into index funds.
Until about the year 2000, index and passive funds were synonymous, recreating stock market indexes. Since then, passive indexing has also included 'smart beta' funds, which invest according to some rules or factors. They are 'actively-designed' but then follow the rules with little or no fund manager discretion. These factor funds now come in a vast range, including value, quality, momentum, equal-weighted, growth and low volatility. Increasing demand for both index and passive led to the rapid growth of Exchange Traded Funds (ETFs) to make it easy for retail investors to gain exposure.
Now the debate has moved to whether these factor funds are truly passive as they involve discretionary design and implementation, and why should smart-beta funds be any better than the active managers who pick stocks? The main feature in their favour is the lower management fees.
Breaking the question into five parts
In a discussion that can become bogged down in semantics, Marks breaks the analysis into five questions:
1. Is passive investing wise?
Passive investing does not ignore the fundamentals and prices of a company. Rather, it relies on active managers to perform the research function and cause assets to be fairly priced. The weightings of stocks in the index come from the prices set by active managers who have done the 'heavy lifting' of security analysis. Index investors can freeload from this work. Ironically, it's not that active managers are devoid of insights, but they set the market capitalisations used by the index.
2. What are the implications of passive investing for active investing?
Over time, it's likely that the majority of share investing will become passively managed. Marks says this will create more opportunities for prices to divert from 'fair' levels as there will be fewer active analysts. It should satisfy a condition for active managers to perform better. Taken to its extreme where there are no active managers, Marks says, "I’d gladly be the only investor working in that world."
3. Does passive and index investing distort stock prices?
Many people argue that flows into index funds drive up the prices of the heaviest-weighted stocks relative to the rest. Marks is not keen on this idea, since stocks are bought in proportion to their weight in the index, no more and no less. Thus if a stock is 5% of an index, it will be allocated 5% of an index fund, and should not impact relative pricing.
But he recognises that not all stocks are part of the major indexes, including the demand from smart beta funds. As more money flows into various passive funds, it causes shares in those funds to rise relative to other shares. With the S&P500 and NASDAQ near record levels, companies in these indices have benefitted from forced buying in vehicles which do not have the choice to avoid overpriced shares. This may eventually have adverse consequences:
"It’s not clear where index funds and ETFs will find buyers for their over-weighted, highly appreciated holdings if they have to sell in a crunch. In this way, appreciation that was driven by passive buying is likely to eventually turn out to be rotational, not perpetual."
4. Can the process of investing in indices be improved relative to simply buying the stocks in proportion to their market capitalizations?
Cuffelinks has written many times about the work of Rob Arnott and Research Affiliates, and I have attended their Advisory Panel Conference in LA four times. Marks cites the work of his 'friend', which argues that the heavier-weighted stocks in an index are more likely to be more highly priced. Should investments go into the more popular, expensive stocks or ones that are cheaper? Marks seems to accept the rationale for investing in an index which weights according to another factor like earnings rather than market caps.
5. Is there anything innately wrong with ETFs and their popularity?
ETFs have driven much of the growth of indexing, but they are simply vehicles for buying and selling assets. Marks says the problem arises from the expectations of the people who invest in them. Some people have a mistaken belief that ETFs are more liquid than their underlying assets. The best example is high yield bond ETFs. Liquidity in these 'junk' bonds can dry up in a crisis, making it difficult for ETFs investing in these assets to meet demand from sellers of the ETF. There may be nothing inherently wrong with an illiquid ETF except for the way they have been sold and the expectations of the investors.
He concludes by saying that the wisdom of investing passively depends on some people investing actively. When passive investing dominates, opportunities for active managers to produce superior returns will improve.
Howard Marks' conclusions from his review of indexing
This section is taken from the summary at the end of the memo.
"For me, the situation regarding index and passive investing is clear:
- Most people can’t and don’t beat the market, especially in markets that are more efficient. On average, all portfolios’ returns are average before taking costs into account.
- Active management introduces considerations such as management fees; commissions and market impact associated with trading; and the human error that often leads investors to buy and sell more at the wrong time than at the right time. These all have negative implications for net results.
- The only aspect of active management with potential to offset the above negatives is alpha, or personal skill. However, relatively few people have much of it.
- For this reason, large numbers of active managers fail to beat the market and justify their fees. This isn’t just my conclusion: if it weren’t so, capital wouldn’t be flowing from active funds to passive funds as it has been.
- Regardless, for decades active managers have charged fees as if they earned them. Thus the profitability of many parts of the active investment management industry has been without reference to whether it added value for clients.
It’s important to note that the trend toward passive investing hasn’t occurred because the returns there have been great. It’s because the results from active management have been poor, or at least not good enough to justify the fees charged.
Now clients have wised up, and unless something changes with regard to the above, the trend toward passive investing is going to continue. What could arrest it?
- More active managers could become capable of delivering alpha (but that’s not likely).
- The markets could become easier to beat (that’ll probably happen from time to time).
- Fees could come down so that they’re competitive with passive investment fees (but in that case it’s not clear how the active management infrastructure would be supported).
Unless there are flaws in the above reasoning, the trend toward passive investing is likely to continue. At the very least, it reduces or eliminates management fees, trading costs, overtrading and human error: not a bad combination.
Of course, there are active investors who outperform. Not most, and not half. But there’s a minority who do earn their fees, and they should continue to be in demand."
Graham Hand is Managing Editor of Cuffelinks. Howard Marks' full memos can be read on this link.