Centre Street Cambridge Corporation

all Street has undergone dramatic change in recent decades. Digitization has radically altered securities trading and back office functions; gone are the bustling crowds on the floor of the New York Stock Exchange, having been replaced by computers and trading algorithms. Up to 90% of trading volume is now conducted without human involvement. Scandals and subsequent reforms have challenged the traditional role of the stock and market analyst, making it difficult for firms to justify their cost. The movement toward fund investing has changed the relationship between brokers and their customers. Greater regulatory oversight has added to compliance burdens.

Movements now afoot threaten to subvert financial markets’ very raison d’etre (price discovery and capital allocation in a market economy) as well as the business models of the firms and financial institutions that carry out that function on a day-to-day basis. In traditional investment practice, funds are committed only after completing security analysis in a selection process known as “active management,” but for several years so-called “passive” — or index based — strategies have attracted increasing amounts of attention and money. In “passive” investing, money is placed into funds that mirror a particular market gauge, most notably the S&P 500 index of large U.S. companies. This method abandons specific-company research in favor of broad market exposure — thus foregoing the process of selecting specific companies or finding unusual investment opportunities — opting instead for “average” market returns.

In the decade since the financial crisis, hundreds of billions of dollars have moved to passive vehicles and away from active funds and traditional investment managers, for reasons that are clear. Market returns have proven quite acceptable, as a nine-year bull market has wiped out the losses and bad memories of the crisis. Index returns in this period have also been better on average than the results achieved by active managers; even the vaunted hedge funds, supposed repositories for top investing talent, have produced mediocre results that are especially galling given the hedge funds’ outrageous fee structures. Another big draw has been the lower fees charged by the indexers; why pay for analytical talent when you can buy a pre-selected basket of securities? Index mutual funds have always had relatively low fee structures, but a relatively new entrant into the market — “exchange traded funds,” or ETFs — has driven fees down to levels approaching negligibility. ETFs are similar to mutual funds in that they invest in a group of stocks (or other securities) that reflect the constituents of an index, but ETF shares trade just like stocks on an exchange (versus once per day for traditional mutual funds), thereby offering the promise of ready liquidity, even when the assets they hold are infrequently traded. ETFs linked to indexes have proliferated rapidly, and now include not only long-established financial markets, but obscure “emerging” markets as well, often providing market access where none was possible in the past (emerging market bonds, for example).

The economic implications of this movement of vast sums into passive vehicles are somewhat theoretical, but worth considering. There is some evidence that price-insensitive buying by passive funds has distorted security prices. If so, the efficiency of the markets’ capital allocation function could become questionable. But price distortion can have other causes as well, as we saw during the dotcom bubble when funds of all kinds bought technology shares at higher and higher prices, often for no other reason than the sector’s strength boosted fund performance.

From the practical investor’s standpoint, there is much to be said for the passive approach, at least at first glance. Their low cost is a very attractive feature, since fees can make a significant dent in returns. Often amounting to only several “basis points” (hundredths of a percentage point) for big funds such as the S&P, the low fees of passive investing compare very favorably with the 1% or more charged by traditional funds (although these fees are now under pressure as well). Passive funds provide ready access to those seeking exposure to a market, and open up previously difficult-to-access investment opportunities to those of limited means — young people starting to fund an IRA account, for example. Typically, low turnover of holdings makes such funds tax efficient as well. As an “active” investor ourselves, it is conceivable that we would find such funds attractive under certain circumstances.

Although passive approaches certainly have their place in an investor’s toolbox, we believe that they are not a panacea or a simple solution to all investment needs. First of all, investors should disabuse themselves of the notion that these products are entirely “passive.” Indexes are artificial constructs, with constituents determined by a committee. Some indexes’ components change frequently and faith must be placed in those whose judgment determines what goes into the asset pool. Furthermore, investing in a fund — passive or or otherwise — is an “active” decision with consequences. Given the plethora of funds now being marketed, investing in funds other than those representing the major market indexes, such as the S&P, gets complicated.

Additionally, the fact that passive approaches have attracted so much interest at this particular time should give reason for pause. Financial assets in the U.S. have been on a tear for the last ten years, driving stock market indexes to serial highs, and interest rates to remarkable lows. Anyone looking at this record could understandably be tempted to conclude that all one has to do to make money in the markets is buy an index fund — and they would be correct, if they had done this at any time since 2009. However, it is a leap of faith with potentially disastrous consequences to assume that such a solution will work at any time. Whether individual stock or bond, or index fund, the price paid matters. If it was so easy to simply buy an index in the midst of the crisis when financial assets were on sale, why didn’t more people actually do it? And why, now, at much higher prices (and valuations) does it seem like a logical choice to so many people? More and more this seems to us to be a typical investment fad that will end badly for many people.

Financial history is full of examples of “bull market psychology” overcoming both analysis and a realistic assessment of current market conditions. You don’t have to go back very far to find an example relevant to our discussion. Index funds were all the rage in 1998-99, at the height of the dotcom bubble, a time which, as many soon discovered, was not as great as it seemed for buying the stock market as a whole (buyers at the top would have to wait ten years to retrieve their capital). A little later, in 2007, a different phenomenon was at work, but one with a similar psychology; after decades of rising property values, people came to believe that property — any property — would never lose value. Due to the crash in real estate, most people have been disabused of that notion.

The one factor which all commentators point to as the major reason for passive investing’s popularity is the failure of active investors to “beat the market.” From this perspective, the overall record is truly abysmal. During one ten-year period, fully 83% of active managers did not match their “benchmark” returns. Even the post-financial crisis bull market has failed to turn the tide for active managers.

In our view, the problem lies not so much in the superiority of the passive approach as in the failure of the active side to, 1) engage in genuine investing, and 2) to be genuinely “active.” The investment management industry has become an institutionalized behemoth engaged in a fierce, intramural competitive struggle to attract assets. Focused on indexes and their short-term “relative performance,” firms collectively gravitate towards market sectors that are in favor at any given time. This is not investing. Fearing “underperformance,” professionals at these firms stick close to their benchmark indexes. This is not being active. What these practices are is a recipe for mediocrity. Small wonder that the passive approach has won such popularity!

In its origins the investment management business saw itself as providing a valuable service to those incapable of doing investing themselves. There were no indexes, and no quarterly investment “performance” reviews. Investments were made for long periods of time, and as such were not expected to pay off immediately. In the current focus on short-term results we believe something valuable has been lost: the value added by experience and a long-term perspective. There are indeed times when it may make sense to “just buy an index fund.” There are also times when it is wise not even to try to match, much less “beat” the market. It is the value of experience, and analysis, that makes these types of distinctions possible.

In contrast to 2017’s smooth ride (the lowest market volatility in decades), trading in 2018 has been choppy. This is reflected in index results for the first half: the Dow Jones Industrial Average lost 0.7%, the S&P 500 rose 2.7%, and the Nasdaq Composite gained nearly 9%. The Nasdaq is home to many of the large technology companies that comprise one of the few market sectors showing any “relative strength” this year. Indeed, remove several of its own tech components and the S&P would be down for the year so far as well.

Fixed income, too, has been weak, with negative returns across most sectors. Average corporate debt prices declined for a second quarter running, the first set of consecutive quarterly declines since 2008. Rising interest rates and falling foreign purchases contributed to the weakness. Massive debt loads across the corporate sector and weaker pricing notwithstanding, ready access to credit continues and rates remain historically low.

Although lacking “momentum,” as Wall Streeters say, the financial markets have been relatively sanguine in 2018, in spite of political instability, rising inflation, increasing debt, and potential trade wars, all the ingredients necessary for a witches brew of trouble under normal circumstances. Tax cuts, government spending, and a generally buoyant economy have probably contributed to the tranquility, which, according to Wall Street pundits, is expected to continue for a while. In an increasingly leveraged economy let’s hope they are correct.

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