In a number of research notes, we have addressed the subject of passive investing and why an increasing amount of investment capital is being allocated to index funds and ETFs. Our two most recent forays addressed the apparent rise of a passive fund-driven bubble and the possible benefits of a so-called anti-ETF ETF.
We do not wish to retread our past analysis too heavily, so we will simply state that, thanks to the increasing amount of capital invested in passive index vehicles, the prices of the stocks that populate them have been bid up far in excess of those that are not included in many indices. We concluded both previous entries with the admonition that value and deep value stocks remain the wisest play for any investor.
The subject of today’s note comes out of that prior discussion. We can see that many stocks have been bid up massively by demand among indices, but what would it look like if this passive bubble were to deflate – or burst?
We’ve been here before
In our prior research notes, we focused more on what sorts of stocks and strategies investors should pursue in light of (and in defense against) the passive bubble. We gave some, albeit limited, attention to the consequences that might be faced by passive investors in the event of a serious market correction:
"The danger is this: Investors allocating to passive funds expect performance that mimics the market, but the insatiable demand for exposure to such funds has itself divorced some of these indices from the underlying financial realities. That may not be a huge problem in a bull market, but it could have destructive knock-on effects in a downturn.
Following the tide of the market may have worked historically over a long period of time, but corrections do happen. Investors buying now are not buying cheaply. A correction could result in years of hurt. Index funds will likely never disappear, but their current extreme popularity is the product of a remarkable bull market, not a long-term view of averaged returns."
We gave little consideration to the specific mechanics of the index funds in the event of a downturn, or to the decision-making of allocators and investors in such circumstance. We acknowledge we should have done more to explain our thinking. That is the principal purpose of this current research note.
Counterpoint from the comments
We see that there is more that needs to be done to justify the case that a serious correction, under the conditions of a passive investing bubble, could cause enhanced harm to passive investors in excess of the market or economy. This point was made quite eloquently by a GuruFocus user stephenbaker, who had this to say in the comment section our our article, “We May Be in a Passive Investing Bubble:”
"Interesting thoughts but there is a counter-argument. In typical bubble scenarios certain stocks or sectors are bid up far beyond IV by investors seeking outperformance. When the bubble bursts, the individual stocks or sectors revert back to, or even below, the mean until the reversion process is complete. Index investing tends to be much more broad in scope. Many (most?) index investors are not looking for outperformance - they are seeking performance in line with economic growth. If/when the underlying economy(ies) decline, reasonable expectations are that the indices will also decline. Unlike some bubble scenarios, index investors are probably invested more for the long run (otherwise, why invest in indices?) and may be less likely to sell when prices fall. In fact, index investors have often been trained to dollar cost average into these investments so that price declines may work in their favor over the long run. I think you have to differentiate between what you deem a 'bubble' and what are natural economic cycles which lead to price rises and declines. Unlike bubbles, in natural cycles, investors' expectations are that prices will decline from time to time. This should not affect many investors' outlooks or the reasons they own stock indices in the first place. Therefore, it is probably not unreasonable to believe that unlike most bubbles, there will not be as many folks exiting for the doors of index funds when the next price decline occurs."
This comment offers an interesting counterpoint to our previous argument. Much of what he says is fair, and well-taken. The general expectation that there will be down years, as well as a subset of conservative investors and allocators with cash on hand to average down during corrections, is a compelling case for why a major stock market drop might not send these investors to the exits or inflict undue pain.
Stephenbaker’s welcome comment reflects a core part of the thesis behind passive investing strategies: accept the ups and downs, since trying to time the market will mean missing the biggest upswings as well. If the market moves in one direction (i.e., upward) over the long run (or very long run), then investors should feel comfortable accepting down years when they happen.
Not a normal bubble
While a correction might cause some hurt, as it always does, to passive investments, investors expect to have some years during which the market corrects. If such years are expected, then irrational responses may not occur as they would during a “normal” asset price bubble.
However, the current passive investment landscape is far from normal, even if the motivations are different from the usual irrational exuberance. There a number of reasons for this. First of all, the current bull market has run on for so long that many investors have forgotten what a bear market looks like – or have never experienced one.
True, retirees, pension funds, and major allocators have undoubtedly been around the bend more than once where recessions and downturns are concerned, but that rarely changes the surprise or horror when things do actually fall apart.
Second, we would point out that the present bull market environment has produced other unusual effects. Disdain for active fund management is at an all-time high (a major factor in the meteoric rise of index funds and ETFs), leading to such funds holding a smaller share of capital and wielding less power. This must be viewed in line with the reasons many allocators have been increasing their positions in index-tracking vehicles.
In essence, the expectation that the market will always rise (an expectation that tends to reach its height just before things flame out) has led to allocations to index funds that might otherwise be deployed elsewhere. In other words, the long-termist view stephenbaker assigns to these investors may not be appropriate to what is ultimately a heterodox group of allocators and investors with a range of expectations.
How a blowup could happen
We can now attempt to answer the question, at last, of what would happen in the event of the passive investing bubble blowing up.
A broad market correction would see stocks across the board take a hit. This is to be expected. But the effects on passive investment vehicles could be magnified thanks to the nature of the bubble. With so many large indices holding the same stocks, prices have been bid up massively. In the event of a market correction, the underlying dynamic (i.e., the composition of these various funds) might not result in undue movement in itself. However, these securities are held by all manner of other funds, institutions and individuals, the passive holders hardly have a monopoly on interest.
When the downturn forces rebalancing and strategic shift, it is usually the stocks that have been bid up or trading at eye-watering multiples that take it hardest on the chin. The resultant pricing dynamic could see the bid-up shares held by index funds decline at a faster rate than the overall market (though the extent to which that could occur is an open question).
Furthermore, the flood of allocations to passive investing vehicles could be interrupted by a downturn. Many investors have been convinced by passive investing evangelists like Vanguard’s John Bogle (who, incidentally, considers ETFs and their impact on the market to be an “abomination”).
But many others have simply seen it as a low-cost means of plugging into the sustained growth story of the stock market propagated through the long years of the bull market. Such investors may lack the “true belief” or genuine confidence in the power of the market return to see them through to the other side. When the upward joyride is over, they may not adhere to the second part of the index fund logic, namely to hold through (or buy during) the inevitable down markets.
Expect some pain
Price corrections in the stock market as a whole could end up being worse for index funds, even temporarily, than the overall market. That could challenge the logic of such funds in general, since they are meant to mimic the market (or specified segment thereof) on both the upside and the downside. Any apparent negative divergence could dent faith in the concept.
The pain of a correction to passive investors could be further exacerbated by selloffs produced by those uncommitted index investors who abandon the strategy in the face of losses. They may know, in an intellectual sense, that index funds will naturally follow downswings as surely as they follow the upswings. But investors in index funds to profit from a low-cost healthy market return may well look elsewhere for superior returns when the market enters a down phase.
Verdict
So there we have it.
It is hard to guess exactly what will happen in the event of a real market downturn, though we hope this analysis has shed some light on why it could end up being ugly for index funds and may in fact be worse than the effect on stock market as a whole.
But this is largely uncharted territory. In 2008, when the financial crisis set off an economic recession and nasty (though short-lived) bear market, index funds existed but were more of a novelty or secondary strategy. In the decade since, we have borne witness to a long and healthy bull market, poor performance among active managers, rapidly falling fees among index funds, and the proliferation of ETFs. That has led to an unprecedented level of passive allocation.
The fundamental structure of the stock market has changed because of the passive investing craze. That means the next downturn could look quite different to what we are used to seeing. Buyers of ETFs and index funds should beware the unknown consequences their holdings might face.
As for us, we will stick with looking for value anywhere and everywhere it can be found. It is a more rewarding strategy than just tracking the market or handing active management to a fund with questionable talents.
Disclosure: I/We own no stocks discussed in this article.
