Has passive investing created a stockmarket bubble?

The US stockmarket is unusually expensive. It has been for some time. And as we’ve seen even in the past week or so, nothing seems to rattle it. Not surging energy prices, not collapsing Chinese property markets – not even a mildly hawkish Federal Reserve.

So what has given the market its Teflon coating? Low interest rates? Technological triumphs?

Or is it something far more mundane – like passive investing?

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Passive funds don’t care about valuations

As long-term MoneyWeek readers will know, we’ve always been proponents of passive investing.

We are keen on active investing too – more specifically, carefully-chosen investment trusts, which have a long history of delivering better results than open-ended funds (such as unit trusts).

But if you are a hands-off investor, or you just want to have some exposure to the stockmarket on your core portfolio, passive funds make more sense than a random active fund chosen with little thought.

Passive funds are cheap and they will give you the same return as the market gives you (less costs). Active funds are expensive and while a decent one might beat the market, the average one won’t. So if you’re not willing to put in the legwork and take the risk, a passive fund is a sensible way to go.

This has become an increasingly popular view over the last two decades. Passive funds accounted for a tiny proportion of the money invested in the stockmarket at the turn of the century. Nowadays not a year goes by without money flowing out of active strategies and into passive ones.

So far, so good. However, some people reckon there’s a problem with this. And while some of it is special pleading on the part of a financial industry which sees its business model being turned upside down, some of it is more convincing.

Vincent Deluard, global macro strategist at broker StoneX, believes that the shift to passive has effectively numbed the US market (where the trend is most advanced). He argues that this is the reason corrections have become smaller, and stock valuations seem to have been kept at levels which are very high compared to the long-term average.

So what’s his point?

If you boil his argument down, it’s quite simple: what changes when investors shift from investing primarily via active managers to investing primarily via passive funds?

The number one difference has nothing to do with the specific stocks bought. It’s about the quantity of stocks bought. Active managers might have a bias to action, but they do care about valuations at some level. So when markets are expensive, an active manager might hold more cash than usual. Passive funds have no such discretion. If you put money in a passive fund, that money goes straight into the market, regardless of how high the Cape ratio – or whatever your preferred value metric – is.

In turn, that means corrections should be smaller. If investors are just buying all the time with no real care for valuations, you can’t expect downturns to last long, because of the sheer weight of money flowing into the market.

The “relentless bid” continues

This isn’t new. Josh Brown at The Reformed Broker blog wrote a piece a good while ago (2014, in fact) entitled “The Relentless Bid, Explained”. He noted that corrections in the US market in particular were becoming shallower. “Sell-offs took months to pay out during 2011... In 2012, these bouts of selling ran their course in just a few weeks, in 2013 a few days and, thus far in 2014, just a few hours”.

Sounds familiar, doesn’t it? Brown’s point then was that the structure of the market had changed in ways that meant stocks were constantly underpinned by a wall of “buy and hold” money.

Why? In short, financial advisors had shifted from being paid based on trading commissions to being paid based on managing their clients’ wealth over the long run. So there was no incentive to trade wildly in and out of the market, and every incentive to take the long-term view.

As a result, “almost no matter what happens, each week advisors of every stripe have money to put to work and they’re increasingly agnostic about the news of the day”.

Now, Brown wasn’t saying this would necessarily last forever – it was just an observation. Thing is, that piece was written seven years ago. And it’s still hard to argue with. The shift from active to passive is just a continuation of this.

But what does this imply for your investments?

Deluard concludes that one answer is simply to say, “if you can’t beat ’em, join ’em.” “The rise of passive is a natural evolution of markets... A core allocation to cap-weighted index funds is the simplest way to benefit from this rising tide.” (For those who are wondering, a cap-weighted index fund is just a simple tracker fund – most indices are cap-weighted.)

The other option, says Deluard (and the two are not incompatible), is to “own the leftovers and be patient.” His point is that the flows into passive don’t just bid up the whole market – they leave the stocks that don’t make it into the most popular tracker funds behind.

That means companies who lack the ESG credentials to make it into certain indices, for example. Or value and small-cap stocks, which Deluard reckons are hardest hit by outflows from active managers.

That said, this strategy of leaning against “the passive bubble” could take a long time to pay off – “decades, not months”. That’s another reason to favour income-yielding “vice” stocks such as oil producers (or tobacco companies, if you’re comfortable with that). You may not see much by way of capital gains in the short term, but you’ll enjoy some handy dividends while you wait.

We wrote more about this in MoneyWeek magazine last year. If you’re not already a subscriber you can get your first six issues free (plus a copy of The Sceptical Investor) by signing up now.