The proliferation of index investing is distorting asset prices — and it may unwind in an ugly way in the future, several prominent investors said recently.
The future of indexing was one of several topics discussed at DoubleLine Capital CEO Jeffrey Gundlach’s inaugural Round Table Prime. The event featured an “eclectic mix” of industry leaders like David Rosenberg, Danielle DiMartino Booth, Steven Romick, Jim Bianco, Ed Hyman, and was moderated by deputy CIO Jeff Sherman.
During the panel, Gundlach noted that the indexation of equities is “the definition of momentum investing.”
He said that buying increasing amounts of stocks already on the rise is “great when you have the FAANGs that are leading the train, and they are getting bigger and bigger,” he said, referring to the high-flying stocks of technology bellwethers Facebook (FB), Amazon (AMZN), Apple (AAPL), Netflix (NFLX) and Google (GOOG).
The billionaire investor added that it presents an “unwind situation” in which the upward trend could shift at a moment’s notice. “When it comes to indexing, it’s remarkable how the pendulum swings,” he added.
‘It’s going to hurt us’
Gundlach explained how, in the mid-1990s, there was tremendous demand for bond indexation. These days, people want indexation for their stocks, while in the 1990s they sought out active management for equities.
Citing a “great fondness” for the indexing of stocks, he pointed out that the appetite for such instruments in bonds is something “nobody really wants.”
He asked: You look at a bond index, and you’re saying, ‘I’ve got a yield of 2.5%, interest rate risk that’s three-times that, or 2.5-times that. I mean, how is this going to work for me?’” Instead, what’s become popular on the bond side in the last three years is “active management on steroids,” the investor added.
Since 2007, there’s been a rotation out of actively managed funds into passively managed indexed equity funds and exchange traded funds (ETFs). Some, however, have raised the question of whether there’s enough underlying liquidity.
Steven Romick, a portfolio manager with First Pacific Advisors (FPA), cautioned about the “liquidity illusion” inherent in passive investing.
“It’s going to hurt us,” Romick said. “You can’t have something that ostensibly is liquid on the surface and yet invest in the yield illiquid. That’s ETFs and other index funds, they’re investing in, particularly in the illiquid.”
He explained that in the small-cap stocks, he’s encountered situations where passive funds hold 40 to 50% of the float.
High yield market fears
Jim Bianco, the founder of Bianco Research, said there’s an “alchemy in the markets” and echoed Romick’s liquidity concerns, especially in the high-yield markets.
He pointed out that riskier corporate debt is being day traded by hedge funds — “a big red flag,” as he called it. As their name implies, high-yield or “junk” bonds offer higher rates than safer, investment-grade debt, simply because they are a riskier bet.
Harking back to 2006, Gundlach mentioned that investors at the time were “repackaging....fundamentally a marginal credit from an investment rate perspective and turning it into a fraction pristine credit. That doesn’t work. No one has been able to turn lead into gold.”
Gundlach said that there are illiquid products, and “we are giving them the clothing of liquidity...How can you have daily liquidity being advertised when the underlying assets have something resembling daily illiquidity,” he asked.
DoubleLine’s chief was one of the few who accurately nailed the credit crisis, famously declaring subprime in June 2007 a “total, unmitigated disaster, and it’s only going to get worse.”
Danielle DiMartino Booth, the CEO of Quill Research, added that in the search of liquidity these days, “it’s going to be the grace of private equity people to give you a decent bid. Good luck with that.”
‘Elephant in the room’
Later the in panel, Bianco brought up what he called “the big elephant in the room,” which is that “the public wants their hand held” by a wealth manager. He added that there are estimates that put the ownership of about two-thirds of ETFs in accounts directed by a wealth manager.
He went on to explain that there are now 13,000 wealth management firms in the U.S. employing 460,000 wealth managers, and they are managing 43 million accounts — which is about 75% of the net worth in the country.
The reason the industry has gotten so big is “we’ve created a very efficient tool for them — the ETF,” he explained. This is what’s driven the “insane fee war” where one firm cuts the fee on its ETF, and suddenly capital flows from another firm into that fund.
Bianco said this role that the wealth manager is playing in flows and asset allocation decisions in the U.S. is under-appreciated. It’s also a strategy that’s “worked tremendously” for the wealth managers.
But if inflation kicks in, it could result in falling stocks and bond prices together — which would be “a real game-changer” for a lot of those wealth managers, he added.