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Doing the right thing for the wrong reason

This post originally appeared at Abnormal Returns on March 2, 2017. You can stay up-to-date with all of our posts via our daily e-mail newsletter.

Are investors doing the right thing for the wrong reason? Jason Zweig in a recent episode of Better Off with Jill Schlesinger asked this very question in regards to the shift of assets from active funds into passive funds. The implication being that once the market takes a tumble, and it will some day, will investors sell their index funds at the depths of a bear market?

The fact of the matter is that the last few years have been a great time to be an (index investor) in domestic stocks, bonds or REITs. (Until recently the foreign equity markets, both developed and emerging, have been a big exception.

Source: StockCharts.com

No matter how you slice the data the shift into lower cost funds is firmly in place. The chart below shows the nearly monotonic relationship between fees and fund flows over the past year.

Source: Bloomberg

The shift into passive funds is putting pressure on traditional asset managers.  Lisa Abramowicz at Bloomberg writes:

Some firms are already merging to create better economies of scale. Others are focusing more on higher-fee funds to manage private debt, equity and other less-liquid assets that can’t be accessed through exchange-traded funds and other indexed strategies.

These small moves by the biggest investment managers are just the beginning. The one thing about pressure is that it can crush or it can transform, but it rarely leaves anything the same.

From an investor perspective this shift makes perfect sense. The math of index investing is unassailable. Index funds on average will outperform active funds. Warren Buffett spent time this week in his annual shareholder letter and on TV talking about this very issue. There nothing investors can do about the billions in fees already paid out but they can be aware of this issue going forward.

A valid question in all this is whether the infrastructure now built up around passive investing is somehow pushing the market to an overvalued state. The risk is that this will in some fashion provoke a backlash. John Stepek at MoneyWeek writes:

Don’t get me wrong. I fully expect passive funds to be accused of all sorts of things when this particular bull market ends in tears, mutual recriminations, and the flinging of suitcases full of clothes out of the window (or something like that).

But I’m sticking with passive. I just won’t expect it to somehow work miracles on markets that are already too expensive.

This argument in a sense falls down if you substituted active equity funds for passive funds. This capital would still be flowing into the stock market. But the point remains. When the time comes indexing will still come under scrutiny. As Jason Zweig at the WSJ wrote:

Wall Street has long mocked the “dumb money” of individual investors who drove markets higher on the delusion that they knew how to pick stocks. Have the same people become more dangerous to the markets now that they’re admitting they don’t know how to pick stocks?

So what is an investor to do? Jesse Felder at the Felder Report highlights the elevated valuations for equities and other asset classes. He argues for low fees in the current environment and urges investors to be well-diversified. Zweig believes we should cut investors some slack and focus on what investors are capable of doing not necessarily what they should be doing in some ideal world. This may include having some pool of ‘funny money’ that allows investors to get their speculative impulses out without doing substantial danger to their broader portfolios.

In this light, indexing is no panacea. Index funds serve a great purpose and have been a boon to investors. However like any innovation they can be used for the wrong reasons. We should recognize today that a backlash is coming. The only question is whether you will be taken in by it or will you have your eyes open to reality.