Highlights

  • Actively managed U.S. equity mutual funds have begun hemorrhaging assets under management (AUM), with the lost AUM flowing directly to ETFs and index mutual funds.
  • Chatter about the adverse consequences of too much passive investing is intensifying, and BCA clients are increasingly asking if a bubble is inflating in passive investing or ETFs more generally.
  • We view passive investing as the surest cure for passive investing and do not worry that index tracking is undermining price discovery or distorting equity markets. Temporary distortions are manna from heaven for professional investors and we would like to have more of them.
  • Active mutual fund management may not be all it's cracked up to be, in any event. The Active Share metric, which measures the portion of a portfolio that differs from its benchmark, has been in steady decline for the last 30 years, indicating that active management practices have undergone a sea change.
  • We have faith in ETFs' underlying architecture and continue to recommend investing in them. They are an efficient, inexpensive and liquid way to gain market exposure and investors need not worry about getting stuck when the music stops.

Feature

Throughout 2017, we have received a thin but steady stream of questions from clients asking about a potential ETF bubble. We note that ETFs do not exhibit any of the characteristics delineated by economic historian Charles Kindleberger in Manias, Panics and Crashes. There is a difference between the increasingly widespread adoption of a useful innovation and a febrile spell of mass exuberance or suspension of disbelief. We have duly expressed the view in one-on-one communications with clients that ETFs shouldn't inspire any particular worry.

The related chatter about a passive investment bubble only seems to intensify, however, and we focus on it in this Special Report. We ultimately fail to see the justification for the most extreme warnings about the dangers of passive investing. Perhaps the emergence and bursting of two bubbles in rapid succession has sparked a mini-bubble in searching for bubbles among academics, investors and reporters. We do not think that the popularity of ETFs is distorting pricing mechanisms, though we would welcome a good distortion to break up the logjam of full-but-not-extreme valuations that portend tepid intermediate- and long-term balanced portfolio returns.

The Active Management Exodus

The causes and consequences may be a matter of debate, but the facts are clear: actively managed U.S. equity mutual funds have been losing ground to index mutual funds for two-and-a-half decades (Chart 1). Before ETFs began to boom ahead of the crisis, active equity mutual funds still managed to attract annual net inflows despite their share losses, but they have now suffered net outflows in every one of the last 11 years. Index ETF and index mutual fund inflows have amounted to nearly 90% of the active mutual funds' outflows, with index ETFs drawing more than twice the AUM as their mutual fund counterparts (Chart 2).

Chart 1
Index Fund Share Gains Are Accelerating
Chart 1

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Chart 2
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Chart 2

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Given the near symmetry of active mutual fund outflows and index fund inflows, it appears that an extended active-to-passive migration is well under way. The move is rational, and has helped investors at the expense of asset managers, as index funds cost considerably less than actively managed funds. (In 2016, the asset-weighted average expense ratio for actively managed and index equity mutual funds was 0.82% and 0.09%, respectively.) If mutual fund managers tend to be wealthier than their clients, the fee savings give the economy a modest boost by shifting wealth to households with a higher marginal propensity to consume.

The Spoilsport Chorus

What's not to like about lower fees for the same, or better, returns?1 Plenty, as it turns out. The myriad objections to passive investing's increasing sway boil down to three major arguments: passive investing undermines price discovery; passive investing undermines capital allocation; and passive investing is potentially anti-competitive.

An index-tracking investor is a price-insensitive investor, and a surfeit of passive investment could undermine equity markets' price-discovery function. Index-trackers are free riders, living off of the active investors whose trading decisions set prices. Just as a parasite cannot live without a host, naive passive investors need price-setters to keep them safe. The passive investing naysayers' heads are filled with images of lemmings rushing over the edge of a cliff after active investors are routed, but we are not so sure.

It's important to remember that the price an investor pays for a security2 is the major determinant of his/her long-run return, and a price-insensitive investor is all but certain to underperform a price-aware investor over time, perhaps by a material margin. Thus the cure for passive investment is passive investment; the fewer active investors participating in the markets, the greater the prospective returns accruing to active investment. Greater prospective returns will draw an increasing proportion of assets until active management is no longer likely to outperform. Then the pendulum will swing back to index investing - lather, rinse, repeat - but skilled security analysts will have a field day while their talents are underappreciated.

Passive investing's impact on markets' capital allocation function is indirect at best. Only primary market transactions channel capital to, or from, ideas and enterprises. Secondary market transactions merely involve exchanges of capital between incumbents and new owners, and index tracking is a secondary-market function. The sell-siders that found passive investing wanting in comparison with central planning would seem to have been trying too hard to be provocative.3 John Bogle is undoubtedly something of a prig, but we'll take him over Karl Marx any day.

The notion that high concentrations of ownership among passive holders could be anti-competitive strikes us as especially strained. The September edition of The Atlantic carries an article with the provocative headline, "Are Index Funds Evil?" and sub-header, "A growing chorus of experts argue that they're strangling the economy - and must be stopped.4" The article highlights a working paper from a team of newly-minted PhDs that argues that high common ownership in the airline industry has been associated with decreased route competition and increased fares. If the same entities hold significant stakes in all of the companies in a particular industry, those entities may have an incentive to collude to restrain competition within the industry and thereby increase the size of the pie for the industry as a whole. This may be so at the airline-industry level, but as
passive owners of the entire market, Vanguard, BlackRock and State Street own considerable stakes in every other industry as well, so increasing the profitability of a single portfolio segment at the expense of other portfolio segments would seem to be self-defeating, not to mention personally risky, given stiff antitrust penalties.

What Makes A Bubble?

Bubbles differ in their specifics, but they share several common empirical characteristics. Kindleberger homes in on the easy availability of credit and its role in enabling the euphoria that fuels temporarily self-reinforcing, albeit ultimately unsustainable, price gains. The gains generated by the headlong pursuit of short-term capital gains are the key to keeping the bubble going, but the upward price movement is halted in its tracks when credit availability slows, and prices plunge like Wile E. Coyote once it's cut off. Neither ingredient has been a part of the ETF boom.

The easy and inexpensive availability of credit has surely contributed to elevated equity multiples (Chart 3) and narrow spreads (Chart 4). The instruments ETFs hold are somewhat pricey and will be vulnerable when the next recession comes, but they are not discounting euphoric expectations that cannot realistically be met. ETF sponsors do not rely on debt; launching an ETF is such a capital-light process that the field is full to bursting with several funds that amount to unfinished experiments. Without the burden of servicing debt, sponsors are free to throw their ideas up against a wall and see what sticks.

Chart 3
Equity Multiples Are Elevated...
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Chart 4
... And Spreads Are Tight
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ETFs are not being bought on margin in any significant degree; they are not the apple of frenzied gain-chasers' eyes. Aside from leveraged ETFs that provide a designated multiple of daily returns, pooled investment vehicles that amalgamate the performance of several securities are hardly an ideal speculative instrument. Index ETFs allow an investor to obtain benchmark returns at low cost and with a minimum of fuss, and are a sane alternative to speculation. As Benjamin Graham put it, the dumb money ceases to be dumb when it acknowledges its limitations, and index investing is an explicit acknowledgement of one's limitations.

ETF Flows Are Not Coming Out Of Thin Air

To the notion that "so much money is flowing into ETFs that it's distorting prices across the board," we say not necessarily. If the money to buy ETFs were materializing out of thin air (as it is in Tokyo and Zurich thanks to the efforts of the BoJ and the SNB), one could argue that ETF inflows are inflating multiples and narrowing spreads. But the money to purchase U.S.-listed ETFs comes almost entirely from sales of actively managed mutual funds. ETF purchases are a reallocation of existing investment capital, not new marginal investment with the potential to move markets.

Just How Active Are The "Active" Outflows?

Chart 5
Correlations Are Falling Despite Indexing's Rise
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On the subject of changes at the margin, if the capital to purchase index ETFs comes from mutual funds that are active in name only, they simply shift cash from one passive pocket to another, and don't amount to any change at all. The professor-investors who created the Active Share metric to measure how much a portfolio deviates from its benchmark5 describe a mutual fund industry that has steadily migrated away from stock picking. By their reckoning, the share of mutual fund assets managed by closet indexers rose from 1% in 1980 to nearly 33% in 2009.6 Using the Active Share calculator at https://activeshare.info/, we find that one-third of AUM in actively-managed U.S. equity mutual funds with AUM of at least $1 billion are held by closet-indexing mutual funds (funds with Active Share of 60% or less).

Our large-fund sample suggests that two-thirds of active fund AUM is truly active. The loss of even that amount of actively managed assets does not appear to have been enough to hijack internal market dynamics. If everyone became an index tracker, and all trades were trades of the entire market, correlations at the stock and sector level would go to 1. Despite ETFs' growing muscle, and their capture of share from stock-picking funds, correlations have been receding over the last couple years (Chart 5).

Investment Implications

We do not believe that the steadily expanding investment in passive vehicles poses a threat to markets or investors. Passive vehicles offer investors the most cost-effective way to obtain market exposure and the actively managed funds they're exchanging for index trackers have become increasingly less active as benchmark indexes have become more prominent. If the passive trend continues, and a rising share of capital is invested without regard for distinctions between companies, the ex-ante returns to active strategies will increase and investors will return to them in droves. In the meantime, if passive investing's share reaches the tipping point, wherever it may be, fundamentally-focused investors will feast on excess returns.

We do not worry that passive investing will weigh on the economy by hindering the efficient allocation of capital to the ideas with the most merit. Index tracking is confined to the secondary markets and will not consign the U.S. economy to a Soviet fate. We view the suggestion that index tracking may lead to collusion among operating companies as unfounded conjecture. Investors need not worry that ETFs are in a bubble, or that investing in passive strategies will be a drag on economic output.

Our review of mutual fund activity indirectly highlighted the cyclical headwinds that asset managers and brokers continue to face. Asset managers will be forced to confront downward margin pressure for as long as commoditized index funds take share from their most profitable bespoke offerings. Index funds trade less than actively managed funds, pointing to lower trading commissions and brokerage profits.

Both the asset management and the investment bank and brokerage sub-industry groups have traded in line with 10-year Treasury yields so far this year (Chart 6). Owning both groups would be compatible with our hawkish rate-hike expectations, but the portfolios already have plenty of exposure to that view. We will therefore not follow our U.S. Equity Strategy colleagues in overweighting either the Financials sector as a whole or the capital markets sub-industry groups. Our model portfolios will remain on the sidelines when it comes to the early cyclicals, concentrating their overweight sector tilts in the late cyclicals and their underweights in defensives.

Chart 6
Capital Markets Stocks Have Become A Rates Play
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Doug Peta, Senior Vice President
Global ETF Strategy
dougp@bcaresearch.com

  • 1 In a typical year, a majority of mutual funds underperform their benchmarks.
  • 2 Price is defined as starting real yield for bonds, and cyclically-adjusted P/E for equities.
  • 3 "The Silent Road to Serfdom: Why Passive Investing Is Worse Than Marxism," August 23, 2016, Sanford C. Bernstein & Co., LLC.
  • 4 Partnoy, Frank, "Are Index Funds Evil?" The Atlantic, September 2017.
  • 5 Cremers, K.J. Martijn and Petajisto, Antti. "How Active Is Your Fund Manager? A New Measure That Predicts Performance," Review of Financial Studies, September 2009.
  • 6 Petajisto, Antti. "Active Share and Mutual Fund Performance," Financial Analysts Journal, July/August 2013.