Ackman, Winters, Druckenmiller And Goodhaven - Investors Need To Beware Of An Index Fund Bubble

| About: SPDR S&P (SPY)

Summary

The S&P 500 has gone straight up since the nasty market bottom of March 2009.

The retail "herd" has been pulling money out of actively-managed funds and plowing it into passively-managed S&P 500 funds.

No less than four very experienced and successful investors believe that all of this money has created an "index fund bubble".

Here at the Superinvestor Bulletin, we make it our mission to keep very close tabs on what the best investors in the world are doing or saying.

When we find several of these great investors making the same investments or saying the same things, we know that we are onto something.

That something isn't always a great investment idea. It can also be that several of these top investors are warning that a certain company or asset class should be avoided.

In the late nineties, following the warning of the world's best investors would have kept you out of incredibly overvalued technology stocks. In the lead up to the housing bubble popping doing the same thing would have kept you out of financials.

Today, we are bringing to you news of several well-known investors warning of a bubble in a very popular asset. The S&P 500 (NYSEARCA:SPY).

Could There Really Be An Index Fund Bubble?

SPY Chart

SPY data by YCharts

You have to admit, it has been very easy for a very long time. From the very frightening 666 low on the S&P 500 back in March 2009, this index of very large stocks has gone straight up.

Really good individual stock picks are supposed to have that kind of increase. The index of the 500 largest companies isn't.

Putting money into passively managed funds has never been more rewarding. Last year, investors pulled $207 billion out of actively managed funds and put a record $413 billion into passively managed funds.

We hate to say this because we ourselves are retail investors. But what the retail "herd" is running away from is usually where you should be looking to invest. And what the retail herd is running towards is what you would normally be best advised to avoid.

In this case, that would mean we should be getting interested in investments outside of the S&P 500 and getting away from the passive funds that mimic the performance of the index.

A Surprising Number Of Top Investors Are Warning Of This

Stan Druckenmiller issued a warning last back in May at the Ira Sohn conference that the party is about to end. We believe his reasoning is sound (no surprise there) and should be paid attention to.

Druckenmiller - The EndGame Presentation

In his Ira Sohn speech, Druckenmiller noted that not a week passes now where he doesn't hear someone extolling the virtues of equities on the basis that there is no alternative but equities with interest rates at zero.

He notes that this view is so widely held that it even has its own acronym "TINA" (there is no alternative). The equities that investors are especially in love with are the ones in the major indexes as evidenced by the fund money flows.

Other top investors are being even more specific in their warning about index funds in particular. We just read Goodhaven Fund's semi-annual investor letter where these experienced investors said:

If you want something other than index performance, your portfolio can't resemble the index. Massive money flows have poured into passive investing strategies, index funds, and exchange-traded funds (ETFs) in recent years, helping to inflate index prices that appear richly valued by historic metrics. We believe looking different is likely to be a material advantage for quite some time to come.

Yes, we get that Goodhaven is predisposed to say this given that they are an actively managed firm. However, you can't really dispute the fact that stock valuations are pretty high for the S&P 500 (see Druckenmiller chart above) or the fact that passive funds have had such massive inflows.

There are other well-known voices beating the same drum.

Last year, in an interview with Wealthtrack, long-time value investor David Winters voiced an opinion about index funds having an inherent flaw. Winters' point was that since index funds are weighted by market capitalization, they tend to hold a disproportionate amount of the stocks that have performed best.

The more that people buy index funds, the more that hot stocks go up which creates a cycle where the biggest and hottest stocks just grow more and more overvalued. Winters believes that there is already a bubble in the S&P 500 that is a danger to investors.

Again, he is biased as an active manager, but his arguments do make some sense.

You can add Bill Ackman to the list of established investors that buy into an S&P 500 index bubble theory. Here were his words from his 2015 Pershing Square annual investor letter:

Index Funds Index funds and other passive managers have gained increasing market share in recent years. Investing capital in funds and ETFs that track major market indexes has recently been what one might call a "one way bet", and there is good reason for this. Index funds and ETFs have very low fees and have outperformed the average active manager in recent years. Last year, index funds were allocated nearly 20% of every dollar invested in the market. That is up from 10% fifteen years ago.

Scroll through the ownership registry of corporate America and the top three holders are typically Vanguard, Blackrock, and State Street. As the biggest managers of index funds, they often cumulatively own 12%, and as much as 20%, of nearly every public company.

As more and more capital flows to index funds - and certain index funds such as those tracking the S&P 500 receive disproportionate amounts of investor capital - the valuation of the indexed constituent companies increases. While some investors consider the valuation of the index components when allocating to specific index funds, many and perhaps most do not. We would expect that many if not most investors picked an index fund when they signed up for their 401(k) plans and never looked back.

What Is An Investor To Do

We think it is a great time to move capital away from a passive index fund and towards active picking of undervalued securities. We take great comfort in the contrarian view when that contrarian bet is against the retail herd moving hundreds of billions in the same direction.

We are doing that at the Superinvestor Bulletin by finding the highest conviction ideas from the world's greatest active investors. One of the most recent reports we issued to our subscribers details a company that a top hedge fund manager has put an incredible 33% of his portfolio into. Clearly, he (a manager who has beaten the S&P 500 by 300% over the past 15 years) believes this company is a unique opportunity. You can join our subscribers through this link.

Thanks for reading. Click the follow option at the top of the article if you would like to get more of our free content.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.