Everyone's An Indexer

Includes: DIA, FCNTX, IWM, SPY
by: Tim Taschler


Passive AUM set to pass Active AUM.

The death of stock pickers?

The rise of closet indexers.

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:

SPY - SPDR S&P 500 ETF - Holdings - Zacks.com

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:

FCNTX - Fidelity Contrafund - Holdings - Zacks.com

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.

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