The End Of The Index Fund Bubble Is At Hand - Passive Outperformance Is Cyclical

by: Superinvestor Bulletin

Since 2006 $1 trillion in cash has left actively managed funds while $1.7 trillion has gone into passively managed funds.

The S&P 500 is expensive relative to history, perhaps extremely expensive.

Not to worry, there are still things to do. Actively managed funds outperform during difficult markets and looking outside the index is the way to go.

For months I've been detailing how some very smart investors believe that the massive wave of cash that has gone into index funds for years now has distorted valuations of the underlying stocks. The main index and the one that I am generally referring to being of course the S&P 500 (NYSEARCA:SPY).

The fact that huge amounts of money have exited actively managed funds and into index funds is indisputable.

At the recent Ira Sohn investment conference Doubleline's Jeff Gundlach presented the following slide which quantified these fund flows:

Source: Doubleline

That is $1 trillion out of actively managed funds and $1.7 trillion into passively managed funds.

What does that matter?

Well, active fund managers generally pay attention to the actual operational results of the companies that they are buying and selling, the future prospects of those companies and the price (valuation) that they are paying for those companies.

Passively managed funds meanwhile pay no attention to any of these things. Passively managed funds receive billions of dollars in cash and immediately dump that cash into the stocks of their respective index.

Price to earnings, debt levels, quality of management are of no concern. These are thought-free investment decisions.

Not only does it make sense that bloated index funds would create overvaluation of the stocks that they are all buying (those in the index), it is a virtual certainty if enough money is poured into passive management.

Are stocks overvalued today? Based on traditional valuation metrics it is hard not to conclude that they are very expensive.

For a little different view I'd like to show you some analysis from the Dshort Daily Digest which focused on Robert Shiller's Cyclically Adjusted Price Earnings Ratio. This measure uses the 10 year average of inflation adjusted earnings as the denominator in the price/earnings calculation.

The intent of the Shiller's model is to minimize the impact of extreme fluctuations in the business cycle on the earnings number. The Shiller calculation takes the current price of the market and divides by the 10 year average of earnings.

Here is where we are the S&P 500 is today valuation wise on this measure:

Source: Dshort

The historical average CAPE price to earnings ratio is 16.7. Today we sit at 29 or 76% higher than the historical average.

That certainly seems expensive which Dshort confirms by estimating that the market today as being in the 96 th percentile in terms of valuation.

Source: Dshort

In this case 96 percent not being a good grade but instead a concerning one.

Outperformance By Active Management Is Likely Near At Hand

I enjoyed Jeff Gundlach's Ira Sohn presentation. Keep in mind that I already was convinced that what he was saying to be true, so you can justifiably accuse me of confirmation bias.

What I also found in his presentation was something a little different which I hadn't really seen captured before. This information is captured in the chart below which depicts the various stretches in time where actively managed funds have outperformed the S&P 500 and where the opposite is true.

Source: Doubleline

What I want you to note is how cyclical this is. We have since 1981 gone through various stretches of both underperformance and outperformance for active fund managers.

Here are the stretches of outperformance by active managers:

-1981 to 1984

-1992 to 1995

-2000 to 2005

-2007 to 2011

Here are the stretches of underperformance by active managers:

-1985 to 1992

-1995 to 2000

-2011 to 2016

When you look at these dates does anything pop out at you? It does for me. Active management does better during difficult stretches in the market and continues to better in the early years where we are coming out of one of those difficult stretches.

When the bull is roaring and fear is less prevalent the passive strategy does better.

Implications For Investors

I you have read this far you are likely aware what my conclusion is going to be. We are now, today, in the second longest bull market of all time. Based on what we have seen historically it should be a surprise to no one that passive management is having its day in the sun right now.

I believe that the clouds are about to roll in. Unless things are different this time we are overdue for good stretch of passive management underperformance. That is usually accompanied by a difficult stock market.

I also believe that now is time for active management to shine, and will do so by focusing on less expensive stocks that are not part of the S&P 500.

We can all do that ourselves either through actively managed funds or directly.

Thanks for reading. Please "follow me in real-time" if you would like to read more of our articles in the future.

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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.