• Phronimos

the rising costs of cheap passive investing

Updated: Jan 11

It is undoubtedly true that for most investors investing via low-cost index funds is the best option to maximize long-term returns after trading costs, taxes and management fees. The academics have long argued that markets are efficient and that active managers, or those that try to ‘pick stocks’, do not beat the market on average after fees.

This is based on the Efficient Market Hypothesis ('EMH'). As economist Philip Pilkington has also pointed out, the EMH is a tautology masquerading as a theory. Critics like Pilkington have noted that the theory effectively states that the average investor will not beat the market on average.

Gee, thanks.

Proponents of efficient markets accept that some managers do beat the market, but they dismiss this as luck, not skill. They call it survivorship bias. If the odds of beating the market are a coin toss and a decade ago 10,000 enterprising new managers started running funds, after ten years simple probability tells us that around 10 of those would have a perfect track record of beating the index. Skill had nothing to do with it.

The final argument made is that even if some managers are able to beat the market, the ability to identify genuine skill versus luck is almost impossible, especially before the fact. The chances are you will be seduced into investing in a high-fee fund by a slick-talking Harvard-MBA-type, who is clearly bright and well-intentioned, but whose confidence exceeds his or her investment ability, is pretty darn high.

So yes, passive investing is still the right approach for most investors. You won’t beat the market investing in index funds but you will come as close as possible to the market return depending on the fees you pay and if you avoid trying to buy and sell in order to time the market.

I would argue, however, that while the fees for ETFs and index funds continue to fall and achieving the market return becomes easier, the true costs of passive investing are starting to rise.

What are these costs?

Firstly, passive investment simply buys securities according to their weight in an index. As a company’s stock price rises, the company’s value increases, it’s weight in the index goes up and the passive fund simply buys more. The process is “passive”, but make no mistake, there is in fact an active security selection methodology at work, which is to buy stocks that have done well and sell stocks that have done poorly. Taken to its logical conclusion this methodology has passive investors putting around 1.6% of their S&P500 index tracking equity portfolio into shares of Tesla on December 21, when the company had a market value of over US$600 billion (much more when you consider option dilution) - a value that represents more than 22 times the company’s sales (not profits, but sales) for the trailing twelve months to September. It joins the index as the sixth-largest company in the benchmark.

Now last time I looked Tesla was in the business of making cars, which is a notoriously cyclical, competitive and capital-intensive business. The best operators in that industry make operating margins in the high single digits and free cash flow in the mid-single-digit range. Even granting Tesla’s ability to scale from a target production level of 500,000 vehicles this year to 1.5 or even 3 million vehicles at some point in the future, with average prices of $50,000 per vehicle and industry leading margins you don’t come anywhere close to the current valuation. The scenario that bullish investors use to justify such a valuation is the promise of an autonomous, self-driving Tesla taxi fleet where the company earns software-like margins on the platform, which is valued using software-like multiples.

Investing based on the promise of products and services that a company may deliver at some point in the future with no experience of doing so in the past is not our style, and comes pretty close to the original concept of ‘speculation’, i.e. guessing about a highly uncertain future. There is nothing wrong with speculation, it just doesn’t tend to pay well over time.

The problem becomes when passive investing itself acquires the characteristics of speculation as it is forced to acquire larger and larger stakes in increasingly overvalued stocks, while dumping shares of companies that have fallen behind. In the past decade winners have continued to win, so the passive formula has done nicely. But buying high and selling low isn't known as the standard formula for investing success in the long run.

An even bigger question is whether the passive tail is wagging the capital allocation dog. And who is holding the tail?

The size of funds passively tracking the ‘market’, thought to be as much as $5.4 trillion for the S&P500 alone, has now become so incredibly lucrative that it is increasingly subject to manipulation by those at the receiving end of the fund flows and by those who handle and direct those flows. The ‘market’ is now a concept whose very definition can create massive amounts of wealth or bestow other forms of influence.

Some time ago we spoke about the inclusion of Chinese domestically-listed 'A-Shares' in the MSCI Emerging Markets Index in 2018. An article in The Wall Street Journal noted that the Chinese authorities had leaned heavily on the index provider, Morgan Stanley Capital International (‘MSCI’), to include Chinese A Shares even though MSCI’s own index standards would normally have excluded those securities given disclosure requirements and issues around currency convertibility. The inclusion drew billions of dollars of capital inflows into China as passive and benchmark-aware active funds were forced to allocate more towards Chinese stocks.

It wasn’t just the Chinese authorities putting pressure on MSCI. According to another article in The Wall Street Journal, it turns out the world’s largest manager of passive ETFs, BlackRock, was also lobbying MSCI to include Chinese A-shares. Why would they do this? Well, shortly after MSCI’s announcement about the inclusion, the The Wall Street Journal reports that BlackRock received approval for a prior application to start a private fund business in China for select investors. As of August this year BlackRock had received approval to set up a wholly-owned subsidiary in China to sell mutual funds, a market from which they had previously been excluded. The potential to sell mutual funds or other financial services to hundreds of Chinese investors with trillions in investible assets is just too tempting for Wall Street's biggest names to ignore. Which is also why those CEOs are all too happy to grandstand on social or political issues in the U.S., but you won't hear a peep from them about a group of heroic kids in Hong Kong literally risking their lives for truly fundamental freedoms like democracy and the rule of law.

As Hannah Arendt wrote of hypocrisy: "integrity can indeed exist under the cover of all other vices except this one. Only crime and the criminal, it is true, confront us with the perplexity of radical evil; but only the hypocrite is really rotten to the core."

One of those two groups of people are heroes and role models and it's not the Wall Street CEOs.

Here you have what appears to be a pretty clear case of both the beneficiary of those flows (Chinese companies, China’s capital account and China’s strategic objectives) and the manager of those flows (BlackRock) using their power and influence to shift the allocation of large amounts of ‘passive’ capital for their own benefit.

The same shift is occurring in the less visible, but significantly larger bond market. As Reuters reported in September, FTSE Russell (owned by the London Stock Exchange Group) announced that it would include Chinese government bonds in its leading World Government Bond Index (WGBI) from October 2021. Analysts from Goldman Sachs predicted the inclusion would drive around $140 billion of passive bond index tracking flows into Chinese bonds. There is no suggestion of undue influence over this decision, but it is notable that only a year earlier FTSE Russell rejected the inclusion on grounds of market access and currency convertibility.

While investors may in good faith debate the merits of these inclusions, what seems increasingly clear is that the forces driving the change are not purely the disinterested efforts of the professionals to best measure and delineate ‘the market’, but rather it is partly the strategic ambition of Chinese authorities to direct capital flows, create ‘buy in’ of Western financial institutions and investors, and to help internationalize China’s currency.

If true, this purposeful redirection of capital could seriously undermine the perceived impartiality of those entrusted with creating and maintaining the indices and reduce confidence in passive investing. To what extent are those same providers subject to other forms of undue influence? What else is going on behind the scenes?

It is a shame because passive investing has been a boon for savers and investors for decades. It seems there is no good idea that Wall Street isn’t prepared to take too far, even something as simple as passive index investing.

I don’t know what the right answer is for everyday investors. Without the time, interest and resources to do your own investing, passive funds remain the best alternative. But to invest passively today is to accept that 1) you are following a buy high and sell low strategy with increasingly speculative outcomes, and 2) your savings are subject to direction by those who may be poised to personally benefit from how those flows are directed.

For those of us who believe that the act of investing requires the active, informed and deliberate allocation of one’s capital, this is just one more reason to be skeptical of the rising dominance of passive investing.

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