The Wall Street Journal ran a series this month commemorating the rise of passive investing. The articles make ‘the case for the triumph of passive’, calling active management a ‘dying business’ because ‘investors are giving up on stock picking.’ Ben Preston and Rob Perrone, from our offshore partner Orbis, explain why while we don’t think investors should give up on active investing, we welcome the growth of passive funds.
The rise of indexing helps investors by calling attention to the many active managers who underperform over long periods. Simple arithmetic suggests that we cannot all outperform. As William Sharpe set out in 1991, the market return must equal the average active return before fees, and active investing is more costly than index tracking, so after fees, active managers should underperform on average.
With passive alternatives available, ‘closet’ index trackers no longer have a place to hide or a reason to exist. No one should be able to charge active fees for mimicking their benchmark.
We agree with many of the criticisms of our industry. But in our view, recent enthusiasm for passive investing also reflects the prevailing market environment, and there we see cause for caution. Markets have seen a high degree of trending over the past few years, and momentum is generally a tailwind for traditional passive strategies. Yet persistent momentum also leads index funds to concentrate capital in expensive parts of the market, and this can be painful when the trending reverses. To understand why, it’s worth considering these points in more detail.
Trending is helpful for traditional passive strategies
Trending is the extent to which outperforming shares keep winning and laggards keep losing. In 2014 and 2015, stock market trending reached the highest levels we have seen in our 26-year history, matching even the exceptional momentum at the end of the tech bubble.
This recent trending has been a tailwind for passive strategies. Traditional index funds hold shares in proportion to their market value, so if a company’s market value increases more quickly than those of other companies in the index, its weight in the index will grow. That is exactly what happens when a stock outperforms, and when winners keep winning, the effect can be powerful.
As a stock outperforms, it contributes to the index fund’s return, and its weight in the index grows. Now a larger portion of the fund, it continues to outperform, making a now greater contribution to performance, and its weight grows larger still.
Meanwhile, as another stock underperforms, it detracts from the fund’s return, and its weight in the index shrinks. Now a smaller portion of the fund, it continues to lag, but it now drags less on performance, and its weight shrinks further.
So long as the trending continues, index funds should perform especially well compared to the subset of active managers who rotate capital out of winners if they look too expensive and into underperformers if they look too cheap.
Trending concentrates indexes in expensive areas
The same forces that help passive strategies benefit from trending can also push them to concentrate capital in expensive areas. This is particularly true if the trending is driven by winners growing more expensive compared to laggards. We believe that is a fair description of markets over the past few years. In April, we wrote that market leaders had almost never been more expensive compared to laggards; today they are still near record levels of unattractiveness. That could be painful for passive strategies if the trends of the past few years reverse, as the experience of the tech bubble illustrates.
In March 1996, technology stocks represented 10% of the S&P 500 and traded at a 40% premium to the market on a price-to-sales basis. They outperformed continuously over the following four years, growing ever larger within the index and making an ever-greater contribution to its return. Helped by this momentum, the S&P returned 25% p.a. over that period. By March 2000, tech stocks had grown to 32% of the index, and their valuation premium had ballooned to 220%. With their valuations and index weight at an all-time peak, they then crashed harder than shares in any other sector.
Risk is the risk of loss, not difference from an index
In hindsight, such a large allocation to expensive tech stocks was clearly risky. But at the time, not owning those shares was painful for many value-oriented managers and their clients. In March 2000, a generic value approach had lagged the market over the preceding 1, 2, 5, and 10 years. Such periods can contribute to a perception that being different is risky, when really there is nothing about an index that makes it low risk. We believe risk is the risk of capital loss, so concentrating capital in winners when they are at their most expensive does not strike us as a sensible way to invest.
Criticising a thought-free investment strategy for its lack of sense may sound strange. But it is worth remembering that index funds still invest in a portfolio of companies weighted by human beings. The difference is that passive strategies consider the views of every human being investing in a market—a group that once included people who were willing to buy technology stocks in March 2000. The group of people managing the Orbis Funds is rather smaller, and they select and weight companies by rigorously assessing the relationship between their prices and fundamentals. Which group of people you would rather have managing your portfolio is up to you.