The rise of price acceptors
This post explores the rise of passive investing and the impact it has had and will have on active investing. Does it make it tougher or easier for active investors to achieve superior returns?
The rise of passive investing in the last 50 years has been phenomenal. Prior to the 1970s creation of index mutual funds, passive investing did not exist for individual investors. Then index funds were invented. The early 1990s saw the introduction of ETFs, also passive vehicles. With the low cost of ETFs and the underperformance of the average active fund manager, passive investing took off.
As of March 2020 passive funds made up 48 percent of the assets under management in equity funds and 30 percent for bond funds, whereas both shares were less than five percent in 1995.
In 2019, there were 2,096 ETFs in the United States. For comparison, in 2017 there were 3,671 listed stocks in the U.S.
Let’s define terms. This comes from a paper titled: ‘The Shift from Active to Passive Investing’, published by the Federal Reserve Board in Washington on May 15, 2020.
“Active strategies give portfolio managers discretion to select individual securities, generally with the investment objective of outperforming a previously identified benchmark. In contrast, passive strategies, including indexing, use rules based investing, often to track an index by holding all of its constituent assets or an automatically selected representative sample of those assets.” (emphasis added)
The Fed paper adds: “Moreover, the growth of passive investing can be seen as part of a larger shift to systematic investment strategies, including smart beta and quantitative investment strategies, which may have significant implications for asset prices, risk management, and market microstructure (Giamouridis (2017)). (emphasis added)
There is another way of looking at and defining passive investing. Passive investing is price accepting investing. ETFs products are bought and sold on the stock market. But, investors who buy those products are price insensitive. They do not investigate the value of the ETF units. They simply pay the market price of the units. The assumption of these investors is that markets are efficient. There is an irony attached to this assumption. Price accepting investing can cause prices to get out of whack with values thereby causing inefficiency. I explore this below.
The other type of investing mentioned in the Fed paper was “systematic investment strategies, including smart beta and quantitative investment strategies.” These are also ETFs and are typically funds managed using factors with no human discretion involved. They might be thought of as active investment funds because they attempt superior results by using backtested quantitative strategies that, looking backwards, have produced market beating returns. They are typically themed, such as small cap fund, value stock fund, quality fund, growth fund and so on. Investors in those funds are also price acceptors. That is, they buy them at market prices without any regard for whether they are receiving value for their investment. The assumption is that the quantitative strategy employed by the fund will produce superior results. Management fees are small because computers do the stock selection based on the factors.
It seems to me that as more and more investors move to what they see as passive investing, more and more investors are becoming price acceptors.
I should acknowledge here that passive investing can produce satisfactory investing results. Passive investing makes it impossible to achieve superior results. Superior results can only be achieved by active investing.
What is investing?
Let’s take a step back and think about what we mean by investing. Some may think of it is putting money to work as part of saving for retirement. There is a more fundamental sense. Let’s see what Warren Buffett says. “What is ‘investing’ if it is not the act of seeking value at least sufficient to justify the amount paid?” (Buffett/Cunningham, 1998)p.85.
Recall Warren Buffett’s words from the 2008 Berkshire Hathaway annual report: “Price is what you pay. Value is what you get.”
For active investors’ the core idea is that they are ‘seeking value sufficient to justify the amount paid’. Passive investors are not. Passive investors either do not recognize that price and value can diverge, or do not accept that they can.
The stock market can be quite inefficient
Warren Buffett offered his view of the market efficiency, writing in his 1988 Berkshire Hathaway Chairman’s Letter: “This doctrine [the efficient market hypothesis – here EMT for Efficient Market Theory] became highly fashionable – indeed, almost holy scripture in academic circles during the 1970s. Essentially, it said that analyzing stocks was useless because all public information about them was appropriately reflected in their prices. In other words, the market always knew everything. As a corollary, the professors who taught EMT said that someone throwing darts at the stock tables could select a stock portfolio having prospects just as good as one selected by the brightest, most hard-working security analyst. Amazingly, EMT was embraced not only by academics, but also by many investment professionals and corporate managers as well. Observing correctly that the market was frequently efficient, they went on to conclude incorrectly that it was always efficient. The difference between these propositions is night and day.” (emphasis added)
Warren Buffett tells us: “Our equity-investing strategy remains little changed from what it was…when we said in the 1977 annual report: ‘We select our marketable equity securities in much the way we would evaluate a business for acquisition it its entirety. We want the business to be one (a) that we can understand; (b) with favorable long-term prospects; (c) operated by honest and competent people; and, (d) available at a very attractive price.’ We have seen cause to make only one change in this creed: Because of both market conditions and our size, we now substitute ‘an attractive price’ for ‘a very attractive price’.” (Buffett/Cunningham, 1998, p.85)
Warren Buffett’s whole approach to investing is premised on the notion that prices and value regularly diverge. He write: “To invest successfully, you do not need to understand beta, efficient markets, modern portfolio theory, option pricing, or emerging markets. You may, in fact, be better off knowing nothing of these.” (Buffett, 1998, p.93) (Emphasis added)
In short, active investor are price sensitive. They don’t simply accept that the price is right.
So called ‘Price discovery‘
Some argue the stock market is becoming more efficient. They say that stock prices (proper fair price) are set by highly sophisticated active money managers. They say that as the ranks of active money managers shrink the average skill of this reduced cohort is increasing, thus reducing price/value discrepancies. This is supposition.
Prices and values diverge for a whole host of reasons. Active money managers, even the most sophisticated and skilled, are under constant short term performance pressures. Companies’ share prices go on sale for a host of reasons. See my post on 20 such reasons. Many active money managers are reluctant to take advantage of these situations. There is no magic here.
I continue to see stocks priced below what they are truly worth. I also see stocks priced above intrinsic value. This is empirical evidence that price anomalies are not arbitraged away or instantaneously or immediately repriced back to fair value. What I have seen is some frothy stocks priced way above fair value. I think here of Tesla. You would think the smartest money that is supposed to cause ‘price discovery’ would have sold enough Tesla stock to bring it back to fair value. It seems the ‘price discovery’ in the market efficiency sense is a myth. For stocks like Tesla the market seems to exhibit a kind of inelasticity whereby excited investors pushing stocks beyond fair value can cause huge price spikes into realms of absurdity.
Impact of passive investing on stock prices
As noted, there are over 2000 ETFs in the U.S. and there has been a dramatic growth in passive investing since the 1970s. Price accepting investors are coming to dominate the stock market.
The 2000 plus ETFs are not passive vehicles. Even an S&P 500 index fund is effectively active in accepting cap weighting. Most ETFs are themed or sector based which invites theme or sector rotation. Rotation is market timing by another name. But, the key thing is that the mass of ETF investors are price acceptors. They don’t distinguish between price and value.
On the passive investing front, when investors flock to any particular ETF the manager has to buy shares in the ETF constituent companies regardless of the price/value proposition. If price acceptor investors start chasing tech ETFs the money has to flow into tech shares. Price accepting investors can drive the price of the index, the theme, the sector or the factor without regard for value.
As an active investor, I am happy that millions of investors, the price acceptors, could care less what they pay and what they sell for.
How prices get out of whack with value
The main driver of market inefficiency is human nature. This will never change.
That is why prices and values often diverge. Consider what Howard Marks has written on this issue: “We learn in Microeconomics 101 that the demand curve slopes downward to the right; as the price of something goes up, the quantity demanded goes down. In other words, people want less of something at higher prices and more of it at lower prices. Makes sense; that’s why stores do more business when goods go on sale.
It works that way in most places, but far from always, it seems, in the world of investing. There , many people tend to fall further in love with the thing they’ve bought as its price rises, since they feel validated , and they like it less as the price falls, when they begin to doubt their decision to buy.” (Marks, The most important thing illuminated: uncommon sense for the thoughtful investor, 2013) p.27. (emphasis added)
George Soros puts it simply: “Rising prices often attract buyers and vice versa.” (Soros, The Crash of 2008 and What it Means, 2008,2009) p.56. (emphasis added)
Warren Buffett is reported to have told Congress on June 2, 2010: “Rising prices are a narcotic that affect the reasoning power up and down the line.” (Marks, 2013)p.101 (emphasis added)
As I see it, the rise of passive investing and systematic investing may lead to greater stock market inefficiency. By this I mean no more than a divergence between price and fair value.
This is because it will lead to more and more investors being price acceptors. The rise in ETF investing is leading to more and more theme and sector investing by price accepting investors. I don’ buy the argument that the average skill level of the shrinking cohort of active money managers is increasing nor that it is making the stock market more efficient.
The rise of passive investing will have little negative impact on active investors. Active investing will still be very difficult. For example, a stock may be seen as underpriced and even a bargain but it may remain so for a very long time. Similarly, an overpriced stock or an overpriced market may remain overpriced for ages. Active investors will still be faced with their own human foibles and other investment psychology issues.
Readers wishing to dig deeper might take a look at the Motherlode Chapter 6. Inefficient Market Hypothesis
And Chapter 25. Investment styles
And particularly these Sections in Chapter 25:
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