Passive Bubble Feedback

This passive investing bubble stuff seems to resonate with investors.

My post last week debunking many of the silly arguments about the passive investing bubble received a ton of views and, in turn, a ton of feedback.

Many of the arguments against my stance that passive investing is not a bubble were of the platitude variety.

I’ve seen this movie before and I know how it ends.

Just wait until everyone rushes for the exits at the same time.

I don’t buy the data you’ve provided.

One of the few responses that contained actual evidence was from a research paper called How Index Trading Increases Market Volatility. Here’s the gist of it:

Assets invested in passively managed equity mutual funds and exchange-traded funds (ETFs) have grown steadily in recent years, reaching more than $1 trillion at the end of 2010. We establish that the rise in popularity of index trading contributes to higher systematic market risk. More indexed equity trading corresponds to increased cross-sectional trading commonality, in turn precipitating higher return correlations among stocks. Consistent with the accelerating growth of passive trading, we discover that equity betas have not only risen but converged in recent years.

The argument here is that the diversification benefits within the overall market have decreased because the individual names are more correlated with one another.

It’s possible index funds and ETFs have caused more stocks to move in lock-step with one another but there may be a correlation-causation mismatch in this argument.

I actually buy the idea that markets are slowly becoming more micro efficient and macro inefficient but higher return correlations among stocks likely has more to do with the fact that financial markets have become increasingly professionalized over the past 25 years or so.

Hedge funds have grown from roughly $120 billion in 1997 to nearly $3 trillion now.1

There are stat arb funds, high-frequency trading firms, and more than 9,000 mutual funds and 5,000 ETFs globally.

The rise in index funds has come during a period that saw a rise in all sorts of more professionally managed products, strategies and firms. It’s likely one of many reasons for the fact that individual stocks may not act as they did in the past.

The other big worries were: (1) people are consistently buying stocks irrespective of the fundamentals and (2) many people believe stocks will always go up over the long-term.

In my last piece on passive bubbles I wondered how people could consider it a risk that investors are putting their money into low-cost, tax-efficient, low turnover funds that outperform the majority of professional investors.

Dollar-cost averaging seems like a similarly silly risk to concern yourself with.

What’s the alternative for normal people who save periodically from their paycheck into a retirement plan or investment account? Time the market?

How many professional, let alone retail, investors have shown the ability to successfully time the market? Should investors continuously wait for a fat pitch with every new dollar of savings they plan to put into the market?2

Good luck with that.

I also don’t get the sense that all index fund investors believe the market contains zero risk. In the past 20 years alone, people have witnessed the stock market get chopped in half twice. If anything, it seems like investors are constantly on edge just waiting for the next shoe to drop.

Are there some investors with unrealistic expectations about what the stock market will do for them in the future? Of course!

But that’s always the case whether we’re talking about index funds, active funds, individual stocks, venture capital, private equity, or Beanie Babies.

A certain segment of the crowd is always going to get too greedy and too fearful.

Something I’ve changed my mind about over the course of my career is the definition of market risk and why it means different things to different investors depending on where they are in their lifecycle.

You can’t simply look at the market in terms of valuations, yields, earnings, or drawdown potential when thinking about stock market risk.

Investing in the stock market is rarely a risky venture for young people because they typically have:

  • tons of human capital but little in the way of financial capital
  • plenty of time to ride out prolonged bear markets
  • many bear markets in their future to deal with
  • the ability to save money over time at lower prices

Stocks are only risky for young people if they consistently try to jump in and out of them, especially after they’ve already fallen. For young investors stock market crashes are inherently not the risk they should concern themselves with.

Investing in the stock market can be a risky venture for older people because they typically have:

  • more financial capital than human capital
  • not as much time to ride out bear markets
  • not as much ability to save money at lower prices

But does this mean older investors can completely ignore the stock market because there is a higher perceived risk involved?

Probably not unless they have a ton of money saved (or a very low cost of living). Older investors may need their capital to last anywhere from 2-4 decades depending on when they retire.

That means you diversify. Get your spending habits in order. Have enough in liquid reserves to see you through the inevitable downturns.

So stock market risks aren’t constant across investors.

There are always going to be risks involved when investing in any financial asset. The risk of a passive bubble is way down the list in terms of things I’m currently worried about when it comes to managing the portfolio of a younger or older investor.

People are very good at pointing out problems these days but not very good at offering solutions. Financial scare tactics are good for eyeballs and newsletter subscriptions.

They’re not very good for developing a successful financial plan.

Further Reading:
Debunking the Silly “Passive is a Bubble” Myth

1I know not all hedge funds trade stocks but the majority trade equities in some fashion.

2Read Nick Maggiulli’s piece on dollar-cost averaging if you think this is a good idea.