Index bubble

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This passive investing/index bubble idea from a Michael Burry interview continues to circulate. The idea has appeal, not the idea that another recession is imminent, but the idea that we could accurately predict one coming, and that the cause could actually make sense to us. The argument is fairly simple. A larger percentage of people are buying index funds, especially the S&P 500, than ever before. Index fund investors tend not to analyze each company in the S&P 500, they simply buy the index which owns all of them. So Burry worries that since fewer and fewer people are conducting analysis on company fundamentals, the prices of these companies are going to be inflated by virtue of the simple fact that they’re included in an index, not because they’re good companies that people believe in. That makes sense. The question then, is how much analysis and trading do we need in order to maintain a decent level of price discovery in the market? If index funds stifle price discovery, how do we avoid a bubble? Here are a few responses:

  • Even a small amount of price discovery (studying fundamentals, making trades, supply and demand) makes a huge difference for prices to reflect value. We don’t need large swaths of the market conducting analysis.
  • If 100% of invested assets were in index funds the price discovery argument might hold some weight. You would have to assume that there would be almost no company fundamental analysis happening, not an unreasonable jump but still an assumption. However, the truth is that only about 45% of invested assets are in index funds, and there’s still a host of investors and dollars outside of passive index funds working to set prices.
  • Index investing actually adds data to the market, it contributes to price discovery. Instead of contributing data on specific stocks, it contributes to larger market sector data as people commit dollars to different indexes across the world, which is helpful market data.
  • Despite the growth of index fund investing, global stock trading volume has actually remained about the same over the last ten years. People use passive vehicles to actively trade. Many index fund dollars are in ETFs among the most traded funds on the market. Just because money is in index funds does not mean that it’s passive. The activity all contributes to price discovery.
  • Some passive investors (like us!) actually do use some fundamental analysis in constructing portfolios (structured funds). And even our passive investors occasionally make trades; in order to rebalance, when they make contributions or withdrawals, etc. Even the most passive investors contribute to price discovery.
  • If the market was losing efficiency and price discovery as a result of growing index fund investors, we would expect to see an uptick in active money manager performance. Active managers would find the mispriced companies in the index and reap corresponding rewards. But the data shows no improvement, active managers have performed slightly worse over the last three years than before.

Despite the uptick in index and passive investing, price discovery is as strong as it ever has been in the stock market. Michael Burry’s comments on the index bubble are interesting and even sound plausible, but upon close inspection look misguided. Passive investing is still the way to go, though you do have permission to dump those index funds.

Are you stock picking?

Stock picking is the art of choosing stocks that you believe will outperform (in which case you’d buy) or underperform (in which case you’d sell) the rest of the market, at least for a period of time. Whether you decide based on some special analytics or just follow your gut, it doesn’t really matter, you buy stocks you think will do well or dump stocks you think won’t. To put it another way, you’re looking for inefficiencies in the stock market. You believe that the stocks you plan to buy are underpriced; if everyone else knew or believed what you do the stock price would already be higher. Or you plan to sell stocks you believe are overpriced; again, if everyone knew or believed what you do, the stock price would already be lower. Naturally, once you’ve made your move, you expect the rest market to catch up and the stock prices to move accordingly.

Stock picking is a normal practice throughout the investing industry, even the prevailing practice. Professionals have been engaging with it since the inception of the stock market, and, with the advances in technology, more non-professionals than ever also have access through convenient investing apps and websites. Stocking picking is everywhere. In fact, most people think stock picking is investing, that they’re one and the same. The above definition of stock picking sounds like investing, doesn’t it? Here are a few reasons why that’s a problem:

1) Stock picking is built on the premise that the market is not efficient, that smart people can find deals and make money buying and selling the right stocks at the right time. The problem is that’s a false premise, the stock market is actually efficient. An efficient market means that stocks are never overpriced or underpriced, there are no deals, there is no right or wrong time to buy. Stock prices move based on future news and information (no one knows the future) and they react to the new news and information very quickly. If you purchase a stock based on an intuition about the future, that’s just guessing. If you purchase a stock because you believe it’s poised for growth based on a new report you read, the stock price has already adjusted to the report’s information, the price has already moved. With improving technology and additional regulation the market is more efficient now than ever before. News is disseminated immediately and trades can be placed instantaneously. There are differing beliefs as to the level or scale to which the market is efficient, but research continually supports the Efficient Market Hypothesis. Since the market is efficient, stock picking doesn’t work by definition.

2) Research into the results of stock picking has been impressively depressing. Study after study shows that no one, not even professionals, has consistent success picking stocks over time. People will outperform the broader market occasionally, maybe even for a few years in a row, but because of the number of people trying that’s a statistical probability, it’s not based on any skill. Professor Russ Wermers stated in a 2008 mutual fund study, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, that “the number of funds that have beaten the market over their entire histories is so small that the False Discovery Rate test can’t eliminate the possibility that the few that did were merely false positives.” He’s basically saying that there are so few active stock pickers who have outperformed the market that they were more likely a product of luck than skill. And that’s the professionals. Stock picking doesn’t work because it’s built on a false premise and the research agrees.

3) Research into the costs associated with stock picking is also grim. William Harding, an analyst with Morningstar, said that the average turnover ratio for managed domestic stock funds is 130% (Apr 23, 2018). That’s a terrifying number. It means that through the course of a year the fund will replace all of the stocks it owns, and then re-replace another 30%. It means that the average stock is held for only 281 days. There is a lot of trading going on here. One of the reasons stock picking fails is because of the additional expenses it incurs for all of these trades. Active funds charge an expense ratio, which is normal (although active funds typically charge higher expense ratios than passive funds because of the additional work it takes to actively trade), but they also incur significant trading costs, which is unique to active funds. The expense ratios are published but the trading costs often aren’t. A 2013 study, Shedding Light on ‘Invisible’ Costs: Trading Costs and Mutual Fund Performance, discovered that the average trading costs of mutual funds amounts to 1.44%, that’s in addition to the already higher expense ratio. Even worse, funds owning higher performing long term asset classes (see Three Factor Model) have even higher trading costs, 3.17% on average for small cap funds. These additional trading fees are debilitating to fund returns.

So stock picking is built on a false premise, it doesn’t work by definition, and it charges a premium for its lackluster results. On top of all of that, there’s a massive cost of lost opportunity when your portfolio is stuck stock picking. While your funds are engaged in the losing strategy the rest of the market is consistently earning great returns over time, returns that can be captured simply with diversification, rebalancing, and discipline. Unfortunately, large swaths of the investing industry still promote the active stock picking strategy, in fact, you’ve more than likely got stock picking funds in your 401k portfolio. There’s a better way to invest.

3 Questions to Ask your Financial Advisor

Your investment advisor is a very important person. You rely on this person to help you navigate your lifelong financial journey, and hopefully guide you to a successful outcome. There are obvious characteristics we want in an advisor: integrity, honesty, diligence, etc., all good things. But there are other, almost equally important things most of take for granted in an advisor: What’s their investment strategy? What’s their view on the market? How do they expect to help you capture returns? These are questions we don’t tend to ask, after all, they’re the professionals, but the answers to these questions will have a profound impact on your future.

  1. Do you think the market is efficient or not?

This is a simple question with massive implications. Basically, you’re asking whether or not your advisor thinks he/she can consistently get you better returns than the market by actively buying and selling stocks (stock picking), moving in and out of different market sectors (market timing), and using funds with the best recent return history (track-record investing). If the market is not efficient then these are valid exercises. An inefficient market means that stock prices could be underpriced or overpriced and assumes that smart advisors should be able to figure out which stocks are which and pick the ones that will outperform all of the others. Unfortunately, advisors don’t consistently beat the market, they can’t consistently pick the winners. The results of choosing stocks and timing the market have been overwhelmingly negative and research has resoundingly supported the assertion that the market is actually efficient (Efficient Market Hypothesis). An efficient market means a stock is never overpriced or underpriced, its current price is always the best indication of its current value. If the market is efficient, that means it’s impossible for anyone to consistently predict or beat it, in fact, attempts to do so are more like gambling than investing. Instead of trying to outperform the market, the goal should be to own the whole of it as efficiently as possible. This brings us to the next question.

2. What Asset Classes Do I Own?

In order to efficiently own the market, you need broad diversification. That means you want to own many companies, but more importantly, you want to own many companies in many different asset classes (large companies, small companies, value companies, international companies, etc.). When you ask, most advisors are going to tell you that the large majority of your money is in Large US Growth companies (S&P 500), which is unfortunate because the Large US Growth company asset class is one of the lowest returning asset classes in history. That’s not to say the asset class is a bad investment, it’s great for diversification, but it’s certainly not where you want most of your money. Small and Value asset classes return better over time, so you want to ensure you’re broadly and significantly invested in those asset classes.

3. How will you help me capture returns?

There are three important components to successfully capturing returns: 1) diversify, 2) rebalance, 3) remain disciplined. Diversification (1) means you’ll have ownership in companies of all different shapes and sizes all over the world. Good diversification does two things for an investor: it reduces risk/volatility and increases return. Since we don’t know which sectors or stocks will do best this year, we own all of them, and then we rebalance, which brings us to point 2. The goal in rebalancing (2) is to keep an ideal percentage of each of the different asset classes in your portfolio. Since stocks and asset classes don’t all move the same way every year when one asset class is up and another is down your portfolio percentages get out of whack. That’s where rebalancing comes in. In order to rebalance your portfolio, your advisor will sell some of the asset class that went up and buy some of the asset class that went down, bringing the percentages back into alignment. This must happen systematically, for example, it could be every quarter, in order for it to be effective. The end result is that you’re automatically selling high and buying low. There’s no gut instinct, no guessing, no market timing, it’s committed disciplined rebalancing, which brings us to point 3. Discipline (3) isn’t something that comes naturally to most of us, but it’s extremely important in capturing returns and planning for your future. There’s a behavior element that all of this hinges on, if an investor doesn’t have the discipline to ride out the ups and downs in the market they can’t be a successful investor. The average investor switches advisors and funds and strategies every 3.5 years, that’s a losing game. So how will your investor help you stay disciplined and on track to capture those returns and achieve your goals?

Since I’m writing this and I’m an advisor, you probably assume I’ve got answers to these questions, your assumption is correct. But this isn’t just a sales pitch, good answers to these questions are critical for successful investing, and far too many people simply have no idea what their advisor is doing for them, whether good or bad. So ask a few questions!