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Some Perils of Passive Investing

Some Perils of Passive Investing

This week, the Wall Street Journal (WSJ) has published at least fourteen articles on passive investing, many of which tout the virtues of the process over active management, particularly for U.S. equity investing.  Passive funds provide an efficient, lowest cost vehicle for individual and institutional investors and I own a couple of flavors of broad market funds in my portfolio.However, the WSJ articles bring up some concerns that deserve reiteration.

Owning the Dying Dinosaur

One of the obvious considerations with passive investing is that you own ALL of the stocks in the category, the rising stars and the dying dinosaurs.  In "You Don't Have to Settle for Average Investing Returns…", Capital Group Chairman, Timothy Armour provides the example of owning Blockbuster vs. Netflix in the early 2000s.  If you had owned a large- or mid-cap index fund, you owned Blockbuster on its way to bankruptcy.  (The S&P stock selection committee typically removes constituents prior to bankruptcy filing but companies will remain in the index for much of the ride down.)  There's no way to mitigate owning the dinosaurs with the rising stars.  If the S&P stock selection committee does a better than average job picking the index components, you might obtain better results than investing in an all-category type of index such as the Russell 1000 or 2000.  However, the committee is mandated to select company based on representation merits, not investment prospects. 

How Much Is Too Much?

As the country's largest investors, pension funds, jump on the passive bandwagon with abandon, one wonders what will happen to market efficiency when the value of assets under active management have declined to a critical level.(See WSJ's "Are Fund Managers Doomed?")What if a company reports a disastrous quarter and the stock price does nothing because so much of the stock is owned by passive investors?There may come a day when the activities of active managers do not have sufficient impact to adjust the price of stocks and provide valuation direction. Burton Malkiel, author or "A Random Walk Down Wall Street", a text detailing the benefits of passive investing and the Efficient Markets Hypothesis (and required reading for most finance students since I was in business school) states, "The paradox is that you do need active management to make the market efficient."Charlie Ellis, the godfather of indexing believes that the theoretical level of passive malaise is perhaps 90%, where there aren't enough "price discoverers" to keep markets efficient.This seems to be a rather high threshold.The WSJ article, "Woebegone Stock Pickers Vow: We Shall Return!" states – 

"Meanwhile, the surge of passive buying by investors means stock are more correlated or increasingly moving in lock step, no matter their prospects, another challenge for stock pickers trying to distinguish among companies and industries.

Over the past five years, the average correlation of the 10 S&P 500 large-cap sectors to the index itself was 81%, according to Nicholas Colas of data-firm Convergex. In other words, sectors have moved in almost perfect lock step.  Members of the S&P 500 move in the same direction on a daily basis about twice as frequently as a decade ago, according to Birinyi Associates, a stock-research firm in Westport. Conn."

Could the investing activities of the large-cap passive funds already be overwhelming the impact of active investors?  The Convergex data says they are.

Passive Aggressive?  Anyone?

In March, 2015, Charles Munger, vice-chairman of Berkshire Hathaway said, "Index funds will be permanent owners who can never sell.That will give them power they are not likely to use well."Corporate activism isn't cheap and minimizing expenses is the second mandate of passive management.In the 2015 paper, "Passive Investors, Not Passive Owners", Wharton professors Todd Gormley and Donald Keim and Ian Appel of Boston College presented research that higher levels of passive ownership result in better corporate government and management responsiveness to shareholders.The author's findings state –

"A 10% increase in passive ownership is associated with a 4% decline in support for management proposals and a 10% increase in support for proposals considered shareholder friendly."

Furthermore, the increased passive ownership is also related to reduced cash holdings, higher dividend yield and suggestive decline in managerial pay.

The managements of Vanguard and Blackrock may have taken umbrage with Mr. Munger's comment.  In the March, 2015 WSJ article "Vanguard and Blackrock Plan to get More Assertive With Their Investment", the firm's executives describe their plans for their passive management operations to pressure corporate directors and executives for better shareholder accountability.  While these passive powerhouses may have stepped up pressure on the shepherds of their holdings for more director independence, better shareholder communications and increased shareholder rights, they don't appear to be using their muscle to rein in excessive executive compensation and golden parachutes.

In a spot check of Vanguard's voting record for its index funds from July 1, 2015 to June 30, 2016, of the 469 proxies which included an "Advisory vote to ratify named executive officers' compensation", only 11 corporations received votes "Against"[1].  Also enclosed in the proxy list were 25 golden parachute provisions.Of these, Vanguard only voted against six corporate managements (24%)[2]. This voting record does not reflect an assertive position by Vanguard[3] regarding named executive compensation.

Watch Your 401(K) Options

Managing a passive index fund isn't a simplistic process where the manager just buys what's in the market basket.I've managed an S&P 500 index fund and a few enhanced index funds.  The smaller the fund, the easier it is to be tripped up by tracking error. (Our results were respectable but passive investing can be just as stressful as picking stocks.)  If you're thinking that it might be best to opt for average returns and select the passive U.S. market index in your 401(k) plan, be sure to check the returns.

A few months ago, I was advising my daughter on her first 401(k) plan enrollment.  The plan is offered by a well-known, national insurance company which I will leave graciously unnamed.  Of the three large-cap, U.S. equity fund options, two were actively managed and had out-performed the S&P 500 in all periods from one month to ten years.  The third option was the insurance company's offering for an S&P 500 index.  The tracking error was HUGE!  And negative.  The ten year annualized return was off by 1.73%.  That's an 18.7% total difference in return relative to the S&P 500.  Always read the fine print, check the dates and compare the numbers.  You may be better off with the active management options in your retirement plan.  Also, beware of the "balanced destination" fund options.  If the S&P 500 index fund is poorly managed, the combined asset plans could be worse.

To wrap it up, passive index funds may not be the marvelous panacea to individual investors as acclaimed by academics, pension funds and 401(k) consultants.  There are serious issues on the macro level with owning the junk and the gems, creating an inefficient equity market and ownership accountability.  On the micro level, we all need to be diligent in our selections as not all passive indexes are well managed. 

[1] The companies which received "Against" votes for "Advisory vote to ratify named executive officers' compensation" were Bed Bath & Beyond, Chesapeake Energy, Chipotle Mexican Grill, Exelon, FMC, General Growth Properties, Oracle, Ralph Lauren, Salesforce.com, Sprint and Time Warner Cable.  Vanguard also voted against shareholder proposals to "Report on proxy voting and executive compensation" for BlackRock and "Disclose the percentage of females at each percentile of compensation" at Exxon Mobil.

[1] Excessive executive compensation has become a particularly irritating issue for me.  This past year, I've been to researching and consulting on more proxy voting for a few merger agreements.  The compensation for the named executives in every merger was appallingly high, dwarfing the compensation for all the unnamed executives by many multiples of ten.  While directors ride a fine line on termination compensation for top executives, these packages are a siren song calling executives to over-stuffed retirement nests, not an incentive to be open-minded about merger opportunities which will ultimately benefit shareholders.

[1] Disclosure: I am the beneficial owner of two Vanguard 529 accounts for my daughters.


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Comments 2

 
Guest - Mike Olinger on Sunday, 30 October 2016 00:42

Well written and a good read.

Well written and a good read.
Guest - Debra McNeill on Thursday, 09 February 2017 10:14

Just read a very interesting article on the NYT website about Seth Klarman, very successful, highly regarded manager of $30B. Here are his comments on passive investing from his recent newsletter as reprinted by the NYT.

“One of the perverse effects of increased indexing and E.T.F. activity is that it will tend to ‘lock in’ today’s relative valuations between securities,” Mr. Klarman wrote.

“When money flows into an index fund or index-related E.T.F., the manager generally buys into the securities in an index in proportion to their current market capitalization (often to the capitalization of only their public float, which interestingly adds a layer of distortion, disfavoring companies with large insider, strategic, or state ownership),” he wrote. “Thus today’s high-multiple companies are likely to also be tomorrow’s, regardless of merit, with less capital in the hands of active managers to potentially correct any mispricings.”

To Mr. Klarman, “stocks outside the indices may be cast adrift, no longer attached to the valuation grid but increasingly off of it.”

“This should give long-term value investors a distinct advantage,” he wrote. “The inherent irony of the efficient market theory is that the more people believe in it and correspondingly shun active management, the more inefficient the market is likely to become.”

Just read a very interesting article on the NYT website about Seth Klarman, very successful, highly regarded manager of $30B. Here are his comments on passive investing from his recent newsletter as reprinted by the NYT. “One of the perverse effects of increased indexing and E.T.F. activity is that it will tend to ‘lock in’ today’s relative valuations between securities,” Mr. Klarman wrote. “When money flows into an index fund or index-related E.T.F., the manager generally buys into the securities in an index in proportion to their current market capitalization (often to the capitalization of only their public float, which interestingly adds a layer of distortion, disfavoring companies with large insider, strategic, or state ownership),” he wrote. “Thus today’s high-multiple companies are likely to also be tomorrow’s, regardless of merit, with less capital in the hands of active managers to potentially correct any mispricings.” To Mr. Klarman, “stocks outside the indices may be cast adrift, no longer attached to the valuation grid but increasingly off of it.” “This should give long-term value investors a distinct advantage,” he wrote. “The inherent irony of the efficient market theory is that the more people believe in it and correspondingly shun active management, the more inefficient the market is likely to become.”
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Thursday, 23 November 2017