The Last Active Investor - A Work Of Fiction

Summary

• The rise of passive management has been the investment industry story over the past 40+ years.
• But all the money can't be passively managed.
• What happens to markets as the passive percentage rises?

July 21, 2039

The satellite trucks are lining the streets in this suburban New Jersey town just as they always do on the third Thursday of every month. As it is July, slightly fewer reporters are wandering around. Quarter-ending months are big and December year-end is the biggest in terms of coverage but still several dozen reporters are waiting for the 3 pm reporting deadline. Microphones, cameras and a podium are set up in front of Charles Morse's modest white raised ranch house tucked in behind a spreading maple tree. Soon the last active investor would be announcing new stock prices.

The Success

How had the pricing of every individual security in the world's largest and formerly most liquid market ended up here? In two words: passive management. First conceived in the 1970's, S&P 500 and other index-based approaches slowly and surely began to gather assets. The addition of ETFs in the 1990's and smart beta passive vehicles in the 2000's accelerated the growth. No investment skill (aka. alpha) was required to launch a new fund or product and by 2015 30% of the stock and bond markets were held by passive investors. The pitch and reason for such explosive growth over 40 years: lower fees and better than average (sometimes top quintile) performance versus active fund managers. Portfolio success became a function of marketing and not investment skill. The money poured in.

Appealing to investors partly via behavioral finance theories like "Loss Aversion" and "Buyers Remorse", index fund marketers succeeded beyond their wildest dreams. Even successful, multi-year outperforming funds that generated enormous incremental life-changing wealth for their shareholders saw outflows. What was never spoken of was the benefit of outperforming the market in terms of wealth creation and passive marketers downplayed the rewards of active management while emphasizing the downside. However, index fund owners don't get particularly rich or donate the new wings to local hospitals, colleges or museums - investors that owned enormously active positions - often in one or two stocks - do. Even Warren Buffett, "The Oracle of Omaha", recommended index funds despite the fact that his massive wealth and the wealth of thousands of Buffet enthusiasts came from long-term active management. Once academic's statement that investors as a whole had underperformed by fees and transaction costs was mathematically accurate but simplistic and misleading. A passive investor would not be a sports fan as all MLB, NFL, NBA and NHL teams had mediocre .500 winning percentages on average every year. That ignored the rewards from winning and being non-average.

The Problem

In the beginning, all was well as passive funds represented a very small percentage of the total stock market value and they could ride on the coattails of active management setting the "right" price for securities as they had little market impact. However, as assets grew, cracks emerged and markets suffered. It was "The Tragedy of the Commons" all over again: a common and free societal resource was overused and destroyed as each individual member of society maximized their own utility with no thought to the consequences of more and more money being run under the assumption that someone else paid for and set security prices.

Academics vastly underestimated what it took to create a liquid and efficient market. Amongst many things they missed: the simple fact that the stock market is not like a supermarket where prices are set by someone: it's a two-way price discovery market and for every ex-post smart informed buyer there needs to be an ex-post dumb uninformed seller as trading is in the end a zero sum game. As fewer and fewer trades were actively oriented, fewer and fewer investors wanted to risk being that dumb seller. It was not possible to have only perfectly informed investors and passive funds, as there then was no one to trade with. The decline in active management also eliminated any price sensitivity to buying and selling and destabilized markets. Active investors typically had price targets at which they bought and sold - as price varied, the supply/demand relationship for any given stock varied. Not so for the passive manager - supply/demand was a function of fund inflows and outflows and index changes but not price. Finally, "The Wisdom of Crowds" said that a group of relatively uninformed individuals could reach a pretty good answer to a problem. Passive management took that crowd away.

Cracks in The Veneer

ETF purveyors touted the tight tracking between their product's performance and that of the underlying index via the intra-day arbitrage relationship between the ETF holdings, the underlying securities and the creation and redemption feature of ETFs. This was true when there were lots of other types of buyers and sellers for the arbitragers to trade with. As the other side of these trades dried up wide swings began to be observed. On August 24th 2015 for example, the iShares Select Dividend ETF (DVY) swung down -35% while the weighted change of the holdings was -2.7%.

The IPO market - a pillar in a capitalist society - also suffered. At one time IPO's were magical: companies, their employees, Wall Street underwriters and investors that had bought the IPO all usually made money. They also performed the critical role of efficient capital formation and allocation in the economy when they funded and rewarded risk-taking innovators and disrupters - the job creators of the future. An American Dream was to build and sell a company and generate wealth. One big problem emerged: IPOs were not part of any benchmark so passive managers did not buy them. Active managers did but often had to make room in a portfolio by selling other similar assets to raise cash. The Uber (UBER) IPO debacle of 2019 was a case in point. Valued at $200 billion on the date of the IPO, the lack of active managers with enough capacity to take down the shares offered and the related one-way selling of like assets to raise purchase cash drove the prices of Facebook (FB), Alphabet (GOOG) (GOOGL) and other stocks down 10% in the week leading up to the IPO and still there wasn't enough demand to fill the book in the original range. Nervous news reports, anxious late-stage pre-IPO mutual fund investors and Congressional threats of investigation and legislation led to an emergency S&P Index Committee meeting. After a lot of hand waving, Uber was jammed into the S&P 500 on IPO date and all was well as the underwriters suddenly had enormous demand and issued more stock above the initial pricing range.[1]

(A small group of anti-capitalist protesters wave their signs from their designated protest area. New Jersey state troopers film them and keep a watchful eye on the group with drones although there usually is no trouble. No body seems to care that much about the "OWS-ies" any more.)

The enormous rise in volatility, first noticed in 2008, can also be linked to the rise of passive funds. Active managers ran portfolios with cash balances. As prices moved up and down they sold and bought in a counter-cyclical fashion, which lent some stability to markets. Not so with the passive manager: no cash balance and no counter-cyclical trading. As passive dominated the market, very modest buy and sell orders had outsized effects on stock prices as there was no one on the other side to trade with. By 2025 the VIX regularly spiked to 80 and something needed to be done.

There was some hope that hedge funds might fill the price-setting gap as their asset size grew to rival that of the more traditional active managers when adjusted for turnover, leverage and lack of benchmark drag. It turned out that the fees were high, most funds over long periods delivered poor performance and in any case often were closet index funds or giant lottery tickets and did little to set prices. It didn't help that in 2021 several large hedge funds were indicted and shut down for hacking into S&P's servers to gain knowledge of index adds and deletes and others were found guilty of bribing back office workers at the major passive shops to share the daily flow data. Traditional SEC insider trading prosecutions plummeted though, as there was no material non-public information that moved stocks any more. The best quantitative models for this period no longer focused on valuation, momentum, capital allocation, quality and/or growth but rather forecasted index additions and deletions.

In the end, massive flows into S&P 500 names also pushed these names far ahead of their non-index held competitors. It was impossible to measure the "true" return of passive strategies as they were being massively funded during the measurement period. The financial market's version of the Heisenberg Uncertainty principle said it was possible to know how an index performed or how much money was invested to track it but not both. Additionally, index member companies started to use the inflated valuations of their stock to buy more lowly valued non-index member names. By issuing stock for the deal the acquiring companies forced the index funds to buy more shares and a vicious circle emerged.

Ironically, the success of passive management was a historical and geographic accident. The U.S. stock market in the post World War Two period delivered such robust returns by itself over most measured long horizons that there was no "need" to get involved with active management. No such claim could be made had the passive industry tried to launch ETFs and passive funds in the US in 1932 as the market was -60% 1928-1931, Japan in 1948 after the market went down -98% from 1936 to1947, Germany in 1949 with a -95% return from 1913 to 1948, Ireland in 2009 after the market dropped -75% in the 2006-2008 period and China in 2018 after a-65% return 2015-2017, and in a host of other markets and time periods. While no historical data existed, active management at least had some hope of avoiding the massive market drops experienced in these countries if they held cash or allocated outside of the local market. Passive management did not.

Solutions

Calls to take action were heard from all quarters. Congress tried a variety of legislative moves: the Fair Security Price Act of 2030 assigned P/E's to companies based on their historic multiples. No one was happy with these prices, companies were motivated to overstate earnings and the committee charged with assigning the P/E's devolved into rank partisanship. The Fama-CRSP next day pricing feed started strong in sample but faded fast out of sample. Congress tried again in 2035 with the Trade Matching Act that legislated that all trades needed to be pre-matched in terms of size and price. Companies tried to manage the trade-induced volatility by actively issuing and buying back stock on a daily basis but had limited capital for this and operated under severe regulatory scrutiny. In the end nothing really worked and noisy, volatile, essentially random prices reigned.

(Clouds are rolling in from the west and the television crews turn their bright lights on. Reporters test the microphones and broadcast short teasers back to the studios describing the scene. Bloggers tweet their observations and send Vines of the scene.)

In desperation the SEC started analyzing orders and trade flow and while 99.9% of the order flow netted back to index buys and sells, one set consistently emerged as non-index oriented. These orders triggered circuit breakers and large price swings despite their small size. With the FBI's big data tools the SEC backtracked the order flow to an old AOL Ameritrade account owned by Charles Morse, a Wharton undergraduate class of 2020 with a Chicago MBA awarded in 2025[2]. The son and the grandson of faceless analysts that had a combined 100 years of investing experience, Charley grew up thinking stocks had price estimates that were a function of proprietary earnings and growth forecasts and that if your target price was higher than the market's you bought and if lower you sold. This archaic technique was referred to in the economic history books as "fundamental research" and managing portfolios based on this research was quaintly called "active management". As a college kid he had built an Excel[3] spreadsheet that used a modified Gordon Growth Dividend Discount Model to price securities based on earnings estimates, growth rates, discount rates and risk premiums. He had little success finding a job in 2025 in the investment business ("A dinosaur" quoted one recruiter) and made a living as a tournament poker player. In his spare time he continued to value and trade stocks in his personal account investing his poker winnings. There were good years and bad years but on average he outperformed the market by 4% with market-like risk. Some additional tax efficiency boosted his after-tax return to 5.5%.

Once he was found he was handcuffed and arrested on charges of market manipulation and insider trading as his price estimates were labeled "material non-public information" and his trading caused wide swings in prices. Then some senior researchers realized he was the solution rather than a problem. He struck a plea deal with the SEC and was released and agreed to, on a monthly basis, preannounce his trades and release his pricing sheet. Companies agreed to issue him stock directly for his buys and buy back his sells. Index fund providers made a special exemption for these corporate transactions and did not adjust the index weights so passive managers didn't have to adjust their positions as they normally did based on shares outstanding.

Present Day

It is 2:45 pm and reporters are gradually walking over to where the microphones are set up and the bright television lights go on. Closing Bell on CNBC goes live as Charles walks out his front door, an old-fashioned computer printout in his hand. Although he has done this dozens of time before, Charles is not used to the spotlight. His rumpled suit, pale face and forehead glistening with sweat belie the power this modest man has. He begins: "After updating my normalized earnings estimates and growth rates, I see undervaluation and will be establishing positions in the following names: buying 1000 shares JPMorgan Chase (JPM) / Wells Fargo (WFC) / Bank of America (BAC), 500 shares of Nike (NKE), 200 shares of McDonalds (MCD) - Chipotle (CMG) and 500 shares of Exxon (XOM) - Chevron (CVX). Since they are at or above my current price targets, I am selling all my shares in Apple (AAPL) - Intel (INTC), Wal-Mart (WMT) and GM (GM) - Tesla (TSLA). As is usual I am also releasing on my web site updated prices for more than 3,000 other securities. With long-term rates declining to 0.5% and my estimate of the equity risk premium falling to 1%, most prices go up, although falling normalized earnings estimates and some growth rates lower prices in several hundred instances. Thank you."

As Charles turns away and walks back inside, CNBC, CNN, Facebook, Twitter and Fox Business News immediately start running "Breaking News" banners with the buys and sells. The tickers at the bottom of the screens and feeds start showing the new prices. Twitter tweets out the new prices and Facebook social networks light up with discussions. Talking heads and bloggers launch into long-winded discussions of the pros and cons of Charley's trades and prices. Research analysts across the industry pour over his numbers and publish research reports. Brokerage companies, exchanges, custodian banks, web sites and mutual fund companies download his file of updated prices and scramble to prepare new statements for their clients. The four companies he bought issue stock to him in his purchase amount and at his price. The three companies he sold buy back his positions in the amount he owned and at the new price estimates. The Federal Reserve issues self-congratulatory press releases on their interest rate policy and credits the stable economic environment for the lower equity risk premium. Companies (and their option-owning employees) with higher prices celebrate; those with falling prices lament their misfortune. Index funds, ETFs, dark pools and exchanges get ready to trade at the new prices as of 4 pm.

The lights go off and technicians begin to tear down the microphones and podium. Reporters do their final stand-ups with Charley's house in the background and throw it back to the studios. The satellite trucks roll off down the road and everyone disperses knowing that in one month it will happen all over again.

Author's Note From 2016

Investors need to be aware of the changing market landscape that higher and higher amounts of passive money potentially creates, including: increased volatility, non-fundamentally driven price action at times and dislocations caused by mega-IPOs. No one wants to pay for them, but everybody wants to use the beautiful security prices our current system creates. Society as a whole desperately needs these prices and we must figure out where they are going to come from going forward. There is no clear answer.

Footnotes

[1] "Investors Get Surge Pricing on Uber IPO" Wall Street Journal, September 19th, 2019.

[2] A wholly fictitious character

[3] An archaic spreadsheet program once marketed by Microsoft.

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. I have no business relationship with any company whose stock is mentioned in this article.