Are Passive Investors Taking On Far More Risk Than They Realize?

by: Jesse Felder

"The average American is from Missouri everywhere and at all times except when he goes to the brokers' offices and looks at the tape, whether it is in stocks or commodities. The one game of all games that really requires study before making a play is the one he goes into without his usual highly intelligent preliminary and precautionary doubts. He will risk half his fortune in the stock market with less reflection than he devotes to the selection of a medium-priced automobile." -Jesse Livermore

These days, the sort of reckless financial abandon Livermore describes is on prominent display in the rapidly rising popularity of, "passive investing." I first addressed this issue two years ago in a post titled, "one reason I'm worried about the rise of the robo-adviser," writing:

…as this form of investing becomes more and more popular, the risk of mispricings (and even bubbles) in the markets grows with it because it completely abandons the basic process of analyzing value and risk. When you have a growing stream of buyers who are agnostic when it comes to value - meaning they will continue to buy regardless of price - it's hard not to see problems arising.

Hedge fund manager, Bill Ackman, recently attempted to quantify the growth of this style of investing, writing, "Last year, index funds were allocated nearly 20% of every dollar invested in the market. That is up from 10% fifteen years ago." Considering the rapid growth in this form of price-insensitive buyers, he comes to a very similar conclusion:

We believe that it is axiomatic that while capital flows will drive market values in the short term, valuations will drive market values over the long term. As a result, large and growing inflows to index funds, coupled with their market-cap driven allocation policies, drive index component valuations upwards and reduce their potential long-term rates of return. As the most popular index funds' constituent companies become overvalued, these funds long-term rates of returns will likely decline, reducing investor appeal and increasing capital outflows. When capital flows reverse, index fund returns will likely decline, reducing investor interest, further increasing capital outflows, and so on.

In other words, "passive investing" will ultimately become a victim of its own success. The massive shift to index funds over the past 15 years or so drove the valuations of the largest index components to levels, which guarantee poor returns going forward. Poor returns, in turn, will guarantee these inflows will turn to outflows and the virtuous cycle becomes a vicious one.

Danielle DiMartino Booth, formerly of the Dallas Fed, takes it another step further suggesting the rise in index investing is, to a great degree, a result of the Fed's conscious efforts to stoke, "animal spirits," over the past seven years or so. As such, it is directly in the crosshairs of its consequences:

"…Investors must reckon with the systemic risk that permeates the markets when boom turn to bust. The bullish cabal continues to insist that if you exclude energy from your calculus, all is hunky dory in the markets. The flaw in such naïve guidance is that excluding energy extends to excluding the commodities supercycle, the emerging markets renaissance it induced and the 'miracle' of China's emergence onto the global economic stage that ignited the engine to begin with. Hence the ultimately systemic outcome of lax monetary policy and the animal spirits it emboldens when seeking out the philosopher's stone. Maybe a bit more business cycle and less artificiality would have left investors in a better place. One thing is for sure - there wouldn't have been the wholesale herding into passive funds these last few years. Market behavior suggests that an entire generation of passive investors is about to discover the downside risk of holding highly concentrated positions that have flown blind, free of price discovery. Call the highly correlated nature of their supposed prudent asset allocation a systemic-risk chaser." [Emphasis mine.]

Ultimately, it's very difficult to argue that in pursuing passive investing strategies to the degree they have recently, investors haven't, 'risked half their fortune in the stock market with less reflection than they devote to the selection of a medium-priced automobile'. And after witnessing firsthand the disastrous consequences of such actions nearly a century ago, Jesse Livermore would be shaking his head right now.