A hot topic among the money management crowd is the amount of money being pulled from active managers (i.e. stock pickers) and placed into passive investment vehicles. Bloomberg predicts that by 2019 passive money will surpass active money: " It will mark a turning point forever etched in the minds of U.S. money managers: the year passive overtakes active investments.”
Passive is basically indexing – allocating money to either an ETF like SPY, which tracks the S&P 500 index, or a mutual fund that owns the same composition as the S&P 500 (i.e. the same basket of stocks). What happens in indexing is that the fund or ETF moves in line with “the market,” in this case the S&P 500. There are ETFs and mutual funds that follow many different indices: The Dow Jones Industrial Average (DIA), the Russell 2000 (IWM), the NASDAQ 100 (QQQ).
Why does this matter? Basically, active managers that underperform the major indices have what is called “career risk.” Many investors have little patience for seeing news about “new all-time highs” in the market while their investment portfolio isn’t growing as much. They then pull their money from that manager or fund and place it into a vehicle that tracks the market. What this can lead to is some active managers, in an attempt to perform as well as the indices, end up becoming “closet indexers” – managers that talk about stock picking but in reality are buying stock in the same companies that are responsible for an index’s performance.
Let’s use the S&P 500 (called SPX) as an example. SPX is a market-cap-weighted index which means that a company's value determines its weight in the S&P. The SPX does not get rebalanced during the year. Instead, the better-performing stocks become bigger parts of the average. Basically, it lets its winners run and is essentially a momentum strategy.
Here is a table showing the largest holdings in the SPY:
Now let’s take a look at a popular (i.e. large) mutual fund with over $124 million in assets, the Fidelity Contrafund, which is an actively managed fund, in other words a stock picker’s fund. The Fidelity Contrafund has been around since 1967. According to the fund description, “This fund invests primarily in the common stock of companies whose value the management believes is not fully recognized by the public.” Based on this, one would expect some contrary (“contra”) holdings, companies that have been unloved by the markets and are undervalued. Let’s take a look at what Contrafund owns:
Looking at these two lists, one sees many of the same names: Facebook, Google, Amazon, Microsoft, Berkshire, Apple, and JP Morgan. If you compare the entire list of holdings for both SPY and Contrafund you will find a lot of the same names. It’s a bit hard to fathom that the most loved (and chased) stocks in the world are trading at values “not fully recognized by the public.” Facebook, Google, Amazon, Apple and Microsoft are value stocks?
Why this matters is two fold. The first has to do with diversification. I met with a prospective client recently who showed me his portfolio of what he called his “diversified holdings.” The problem was, when I looked at the actual holdings of his ten different mutual funds, they all owned virtually the exact same names, just like SPY and Contrafund above. So even though this person thought they were diversified, the reality was that they were 100% “in the market.” Not only that, roughly 50% of the portfolio was in the same 10 stocks.
Being “in the market” this way, as a closet indexer, makes life simple as one only need “follow the market.” If the headlines are that “the market” is up 10%, so is the investor, and if “the market” is down 10%, so is the investor. No one feels too bad as “everyone” basically performs the same way. This is the herd mentality at work.
The second implication of this closet indexing is that that are a whole lot of people who own the exact same thing, namely “the market.” This has worked well for indexers on the upside, but might be problematic on the downside. As trader, philosopher and author whose 2007 book The Black Swan was described in a review by The Sunday Times as one of the twelve most influential books since World War II, Nassim Taleb says: “My personal adage is: The market is like a large movie theatre with a small door. And the best way to detect a sucker (say the usual finance journalist) is to see if his focus is on the size of the door or on that of the theater. Stampedes happen in cinemas, say when someone shouts “fire”, because those who want to be out do not want to stay in…”
With more and more money pouring into passive vehicles, more and more people and institutions own the same names. If (or I should say when) people start selling, it will be interesting to see who wants to stay in the theatre and who wants out. We all have to hope that no one yells “fire.” However, when one studies the history of markets and human psychology, one can’t not be concerned. After all, we’ve seen this movie so many times before. Whether the star of the movie was tulips, beanie babies, dotcom stocks or real estate, the ending was the same. We had an equity bubble in the late 1990s that crashed and was bailed out by the Fed, causing a real estate bubble. That led to a bigger problem in mortgage debt that crashed in 2007-2008 and was bailed out by the Fed (and other central banks around the world) printing trillions of dollars and using the newly created money to buy bonds and, in some case (Japan, Switzerland), stocks, all with the intent of trying to keep the wheels on the global economic bus.
In concluding, it’s worth noting, in this author’s humble opinion, the herd is already stampeding. A da Vinci painting recently sold for a record $450 million. Real estate and stocks are at new highs. And probably what is the most telling example of the excesses of money printing, bailouts and the madness of crowds is the fact that an electronic coin that no one can touch, see, or safely store (let alone easily spend) is now worth $19,000. As Taleb pointed out, it might be wise to take a look around, keep an eye on the size of the door, and don’t just focus the size of the theatre, no matter how enticing the vision.
Past performance does not guarantee future results. The views and opinions expressed herein are those of the author’s as of the date of this commentary, and are subject to change without notice. This information is for information purposes only and is not intended to be an offer or solicitation for the sale of any financial product or service or a recommendation or determination by Sprott Global Resource Investments Ltd. that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on the objectives of the investor, financial situation, investment horizon, and their particular needs. This information is not intended to provide financial, tax, legal, accounting or other professional advice since such advice always requires consideration of individual circumstances. The products discussed herein are not insured by the FDIC or any other governmental agency, are subject to risks, including a possible loss of the principal amount invested.
Generally, natural resources investments are more volatile on a daily basis and have higher headline risk than other sectors as they tend to be more sensitive to economic data, political and regulatory events as well as underlying commodity prices. Natural resource investments are influenced by the price of underlying commodities like oil, gas, metals, coal, etc.; several of which trade on various exchanges and have price fluctuations based on short-term dynamics partly driven by demand/supply and also by investment flows. Natural resource investments tend to react more sensitively to global events and economic data than other sectors, whether it is a natural disaster like an earthquake, political upheaval in the Middle East or release of employment data in the U.S. Low priced securities can be very risky and may result in the loss of part or all of your investment. Because of significant volatility, large dealer spreads and very limited market liquidity, typically you will not be able to sell a low priced security immediately back to the dealer at the same price it sold the stock to you. In some cases, the stock may fall quickly in value. Investing in foreign markets may entail greater risks than those normally associated with domestic markets, such as political, currency, economic and market risks. You should carefully consider whether trading in low priced and international securities is suitable for you in light of your circumstances and financial resources. Past performance is no guarantee of future returns. Sprott Global, entities that it controls, family, friends, employees, associates, and others may hold positions in the securities it recommends to clients, and may sell the same at any time. The author received no compensation for writing this article.
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.