Are we all wasting our time?

31st Dec '23 by donald pond

17 comments 1139 reads

I just saw this on LinkedIn. For the first time, ETFs and passives outweigh actively managed funds in the market. Of course, with the rise in "smart ETFs", not all ETFs are passive, but equally, a fair proportion of funds that claim to be active largely track their benchmark, so perhaps that evens itself out.
Buffett famously said that in the short term the market is a voting machine, but in the long term, a weighing machine. In other words, day to day valuations may be determined by what is popular and in fashion, but in the longer term, quality and value will come good. That is, perhaps, the philosophy behind Stockopedia.
But what if the rise of passives mean that the market is permanently a voting machine? We see statistics all the time about how the magnificent 7 are now around 25% of the US market, and Apple is bigger than the combined stock markets of the UK, France and Germany (IIRC, you see figures like this all the time). It is difficult to gets statistics on the amount of new money going into funds each year, but that chart suggests a trend of new money going disproportionately into passive funds. Worse, as money is pulled from active funds, stuff that is being held on the basis of value is sold and as the money is transferred to passive funds, it goes to the stocks that are already at the highest valuations. Every pound or dollar that goes into a US tracker, or MSCI world, or, to be frank, most investments, will see a fair proportion going to buy the magnificent 7.
Where, in this situation, do we get price discovery?
I think we have seen a lot of this in markets over the past decade. There's been a lot of selling of the UK market in general (I think I recently saw redemptions from UK funds have outpaced investment over the last 26 months) and a lot of buying of the US market. Anyone who knows the US knows that most US investors wouldn't think of buying a non-US company: they believe - not unreasonably - that the US is home to the world's best companies and owning shares if part of their culture. And so we have seen UK stocks get cheaper and US stocks more expensive, and keep on…

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john2

31st Dec '23

'most US investors wouldn't think of buying a US company'

Do you mean 'most US investors wouldn't think of buying a non-US company'?

By the way, I think there is a lot in what you say. If I had invested all my money in an S&P500 tracker in 2009 I would be a great deal wealthier than I am now.

donald pond

Yes, good spot.

Chris Brown

1st Jan

Interesting post, thank you. I wonder if it means there will be more opportunities for active stock pickers, as a greater number of investors simply buy the index and good single-stock opportunities are increasingly overlooked.

It also implies momentum will become a more important factor. As companies become larger, the ETFs will buy into them.

It's notable that UK small caps have no real passive investment options. iShares MSCI UK Small Cap UCITS ETF GBP (Acc) (LON:CUKS) for example is mostly FTSE250, and AIM has no trackers at all. Undoubtedly this is a headwind for UK small caps, if the average investor is pivoting to passives.

Edward Croft

There's a lot of regulatory capture by index funds in the USA. I believe 95% of every $1 invested by investors under the age of 40 goes into an index fund. Regulation has essentially forced this, as apparently company pension fund administrators are now personally liable if employee funds underperform the market - hence every administrator just chooses index funds.

That's a toxic investment system in my opinion, which encourages misallocation of capital - how does it make sense to have 95c of every $1 being invested with a single investment rule "invest proportionally to company market capitalisation"? Of course it's not necessarily a misallocation of capital when the US anti-trust system appears to turn a blind eye to monopolies - so the tech titans truck on and on unimpeded.

But there's plenty of history to suggest that this kind of largesse eventually breaks down.

The word "anti-trust" actually comes from the set of laws designed to break down the power of the late 19th and early 20th century "trusts" - which were huge conglomerates/monopolies which manipulated markets, stifled competition and dictated prices.

One could argue that the same thing needs to happen again - to tackle the concentrations of power in market structure, public and private equity and so on. Plenty of great commentators out there - everything by Mike Green on index-funds/passive. I've also enjoyed "Plunder" which outlines how private equity is pillaging the US economy.

In the meantime, the index fund dominance actually creates huge momentum swings in big cap shares. So there's great profits for mo-mo traders to be had in US stocks!

2nd Jan

Wow, I wasn't aware that it was 95%, more or less through compulsion. That is insane and the very definition of bubble behaviour. But the other side is that the bubble can continue inflating - in fact, has to continue to do so - for as long as more assets are going into the market than are coming out. If that ever changes, then who knows what would happen?

M48

If so much money is blindly getting allocated across the whole market via trackers, I don’t really get why the ‘magnificent 7’ alone seemingly drove the performance in the S&P - in absolute terms I get why they get more $ investment (because of the market cap weighting), but surely in percentage terms, the growth would show itself more evenly? Does there not have to be another explanation?

rmillaree

We just dont know what the future will bring and even if we go passive which one do you go for.

I can easily see scenario where half the big 7 lose their way and end up going into terminal decline - i would not put high probability on that but i could easily see scenario where dow 100 weighted tracker produces negative or nil return for 10 years. I think though trackers do probably make sense for most peeps especialy for the less disciplined investors - to me i have realised the main trick is to stay away from the disaster investments - i have learnt that the hard was repeatedly having large losers in my portfolio - thankfully here the stock ranks and the excellent commentary at least tend to flag most risky stocks as being such albeit there will always be disasters we dont see coming.

"That's a toxic investment system in my opinion, which encourages misallocation of capital - how does it make sense to have 95c of every $1 being invested with a single investment rule "invest proportionally to company market capitalisation"?

If the "index" as a whole is delivering 8-10% pa compounded over 50 years - is the most sensible thing to do not simply to do exactly that ? - by allocating on size you are following the market and sharing in thne growth of the big winners which you would probably miss out on otherwise unles you are lucky enough to be overweight on them?

I would say the s&p has probably over performed due to the fantastic returns of the top 7 - so its to me its very unclear where the future lies.

Note i would guess there is clever money at play here - so if stuff is clearly overpriced on underpriced - i would kinda guess that the clever money is scooping up soem margin behind the scenes - perhaps on the scale involve though it sorts itself out as if hari seldon has written a rule that at scale the market will actually be efficient.

"It also implies momentum will become a more important factor. As companies become larger, the ETFs will buy into them."

I think the price reaction to trading updates says this theory is nonsense - all companies will die by the sword irf their trading updates dont roughly match expectations medium term.

- all we know is that by following the market you will have decent wad in the winner at the end of the day.

Note to a certain extent short term i would agree momentum would certianly play a part - i think there is some excellent evidence that stock overshoot at the top due to positive momentum and can do te oppsoite when newsflow is bad - tehn momemtum is only such till it turns - hey ho perhaps the chartists are the real hari seldons amongst us- go with the flow till it stops.

JonBeddell

Hi Donald, interesting thoughts. I think when active is becoming so unfashionable it’s probably exactly the time to position against the passive funds! You answered your own question when you mention Mike Green’s concern about this working in reverse. The M7 have ridden a self perpetuating wave the last year or two. Inevitably the market will reach a fulcrum where investors see opportunities being active (underweight and then ultimately short M7) and funds will redistribute towards other areas including both passive and active participants. The only question is when will we reach the fulcrum, and that’s anyone’s guess. I think to some extent the same is true of the US/UK disconnect. I feel that from current levels I will avoid M7 and indeed the US, and continue to focus on quality undervalued companies in the U.K.

As another poster says, it’s a pity that there are no ETFs tracking U.K. small caps or AIM. I have recently loaded up on FTSE250 ETFs which are an imperfect proxy for what I believe will do well in 2024.