While much ink has been spilled on the topic of active investing versus passive investing, the recent memo by Howard Marks, the Chairman of Oaktree Capital Management, did a good job of parsing through the topic with his usual lens of rationality. Given the ongoing shift of assets from active strategies into passive funds, it is worth expounding on the topic and drawing out any implications for active managers.
First off, it’s worth recounting what index funds are. An index fund is a type of fund that emulates or tracks a market index, which is a basket of stocks such as the Standard & Poor’s 500 Index (S&P 500). Notably, the purchasing decisions to assemble the portfolio are systematic, and are based on the relative weightings of each stock that comprises the index. A corollary of this is that there is no analysis being performed on any of the stocks: no one is reading company financial statements, crunching the numbers, and determining whether that particular stock represents good value. If a stock is in the index, then it will be purchased indiscriminately in order to recreate that index.
Whilst there are very low fees, and minimal trading in an index fund strategy, you are getting what you pay for: average performance at best. As Marks frames it: “index investing is a “can’t lose”strategy: you can’t fail to keep up with the index. Of course it’s also a “can’t win”strategy, since you also can’t beat the index (the two tend to go together)”.
Regardless of this promise of just average performance, there has been no shortage of enthusiasm for passive investing. Marks cites an article from the Los Angeles Times, dated April 9, 2017, which revealed that $1.9 trillion in assets are held in passive strategies by conventional U.S. stock mutual funds, and this is triple what they held in 2007. Part of this has been driven by a prolonged period of underperformance for many active managers, with many failing to justify the fees they charge.
Despite this, active stock selection is still crucial for the efficient functioning of markets due to the price discovery it provides, and this is especiallyso in a world with a growing proportion of assets being allocated to passive funds.
One of the most insightful passages from Marks’s memo that underscored the need for active investing was the following:
Is it a good idea to invest with absolutely no regard for company fundamentals, security prices or portfolio weightings? Certainly not. But passive investing dispenses with this concern by counting on active investors to perform these functions…
In short, in the world view that gave rise to index and passive investing, active investors do the heavy lifting of security analysis and pricing, and passive investors freeload by holding portfolios determined entirely by the active investors’decisions. There’s no such thing as a capitalization weighting to emulate in the absence of active investors’ efforts.
The irony is that it’s active investors –so derided by the passive investing crowd –who set the prices that index investors pay for stocks and bonds, and thus who establish the market capitalizations that determine the index weightings of securities that index funds emulate. If active investors are so devoid of insight, does it really make sense for passive investors to follow their dictates?
The important implication from the above is that if most of the money invested in equities were to one day become passive, then markets –due to the absence of active investors scouring for mispricings –are likely to become less efficiently priced.
It is unclear at what point –in terms of the proportion of equity mutual fund capital that is invested passively–that markets will lose price discovery (Marks suggests that currently around 40% of all equity mutual fund capital is invested passively). What is clear, however, is that as a greater proportion of assets are invested passively, the chances of mispricings increase, given an increasing number of purchasing decisions based on non-fundamental criteria. This could lead to an environment that creates opportunities for active investors to generate investment outperformance.
George Hadjia is a Research Analyst with Montaka Global Investments. To learn more about Montaka, please call +612 7202 0100.