Most of us are familiar with the term anti-vaccer. An anti-vaccer is an individual who is opposed to the use of vaccinations which prevent the contraction of disease. Despite popular arguments to the contrary, an anti-vaccer is highly rational.
The anti-vaccer benefits in two ways. First, they avoid the costs of getting vaccinated: time at the doctor’s office, pain from a needle in the arm, mild illness associated with the vaccine, and any negative long-term effects we don't know about, or effects they personally believe in.
Second, the anti-vaccer benefits from avoiding the diseases the vaccine is intended to inoculate against. As long as the vast majority of the population does vaccinate—maybe greater than 80 percent of people in an area—the diseases are generally inactive and do not spread.
In this sense, being an anti-vaccer is the best personal choice. No pain, all gain. However, it only works to the extent that the larger population does take the vaccine and the diseases remain dormant.
If too many people refuse vaccination, diseases will spread and are likely to take out the anti-vaccers as well as those who vaccinate due to slight mutations which may render the vaccines ineffective.
Benefits of the Index
This brings us to the financial markets. We live in a time where an increasing amount of money is invested in the markets in the same rigid style—tracking a major index such as the S&P 500 or the S&P U.S. Total Market Index or some similar variant of these at a very low cost.
Indexing is highly rational. In theory, somewhere out there, millions of market participants evaluate listed corporations. They buy or sell stocks which establish their individual value. This may be through direct investor participation or via professional managers.
Investors buy companies they believe will rise in price, rewarding good management and good products or services. Investors will sell, or even sell short, those companies who offer poor products or services or are mismanaged.
We know that evaluating corporations for financial purposes costs money. There’s a substantial amount of research involved, analysts must be paid, money managers assume financial risks, office space is leased, regulatory requirements must be met, and naturally profits must be earned.
On the other hand, an index reflects much of the hard work taking place behind the scenes. Companies that active market participants value highly will rise in price forming a larger part of the index; companies which are valued poorly form smaller parts of the index.
Someone who simply buys a fund that tracks the index benefits substantially. Not only do they completely avoid paying the costs of active management, they benefit from a significant portion of the work done by active market participants. As I stated earlier, being an indexer is a highly rational and even a smart strategy.
Elements of an Index-driven Market
However, indexing carries a real hidden danger that is lurking within its design. It’s something to be aware of because we may be near the danger point.
Indexing works very well under two conditions. First, there must be a substantial amount of money investing in an active style to appropriately value underlying securities. Second, there must be a substantial net inflow of outside money into stocks to drive prices higher.
Active Share in the Market
On the first point, the latest research from Moody’s suggests approximately one-third of assets are now passively invested. This is set to grow to one-half of all assets as early as 2021. Moody’s counts only the funds which are explicitly passive.
Back in 2006, Yale University researchers found one-third of active managed funds were actually “closet indexers”. Closet indexers charge high fees and claim they are active, but they effectively track the index very closely with their holdings and performance.
This infiltration of closet indexing is mainly due to the trend of benchmarking to an index, the fee structure of most funds, and difficulty in allocating large amounts of money in a highly differentiated manner.
Closet indexing was rising rapidly across active funds already back in 2006. We know it was particularly prevalent in large-cap funds and the funds with the highest assets under management.
While it’s anyone’s best guess over a decade later, I would not be surprised if well over 50 percent of assets in the U.S. market are either in index funds or closet index funds.
Inflow into the Market
On the second point, we know investors behave in a herd-like manner. Money flows into the market when markets perform well and money flows out of the market when performance is poor. However, there is a larger issue looming.
Around the developed world, we are seeing a shift where a large amount of wealth is held by people moving into retirement. As these retirees stop contributing to their portfolios and start pulling out money to live from, money flow might begin to drop in a sustained manner—a worrisome trend.
Also, money flows are often closely associated to the overall money supply. As central banks around the world tighten the money supply, less new money is available to be invested in the financial markets.
Dangers Lurking in Index Fund Design
By their mandate, an index fund must invest their funds in a manner that closely reflects the underlying index which they follow. This means if a S&P 500 fund experiences inflows, it will inject those dollars exactly in the index weightings.
Currently (January 2019) for every $100 in inflows, the fund will buy $3.69 of MSFT, $3.13 of AMZN, $3.12 of AAPL, $1.79 of BRK-B, $1.59 of JNJ, and so on. This systematized buying drives up the value of these big names, even if they are not deserving of the "purchase at any price" methodology.
However, the inverse is also true. In a scenario where net inflows turn to net outflows, these same funds will sell the index constituents in their exact weightings.
Unlike the true active manager, there is no control mechanism in place in an index fund to hold the best companies or those with appealing valuations. Everything must get dumped out of the fund without consideration to any outside factors.
A closet indexer must follow the selling simply to avoid holding falling stocks and again failing to meet their index benchmark. Obligated selling begets discretionary selling, forming a vicious circle.
This worse case selling scenario could have a drastic impact on the markets, especially a market where maybe 50 cents of every dollar is forced to participate in selling regardless of price.
Shiller’s research on the 1987 crash suggests that roughly 10 percent of institutional money and wealthy investors had stop-loss mechanisms in place. Less than half of these were in the form of mandated portfolio insurance as part of their prospectus.
This means at most a couple percent of equity market assets were forced to sell into the crash. We now know this small percent of obligated selling caused a vicious selling cycle, ultimately causing the largest single day drop in U.S. stock market history.
Now we are in a system where ten or twenty times the market participation seen in 1987 is mandated to sell if investors flee these funds. If a virus takes hold, the devastation could truly be epic. Financial markets, particularly in the U.S. large-cap space, could experience contagion.
Strategies for Investors
Despite the gloomy thoughts I share in this post, I still believe index funds are the best way to invest for most investors in the current environment for several reasons.
When it comes to investing you should always act in your own self-interest. Why would you not choose low-cost funds that benefit directly from the efforts of active market participants?
There’s also the idea of “damned if you do, damned if you don’t”. If my vaccine analogy holds, a market decline would be felt harshly by those who index as well as those who are active market participants.
In other words, as a virus can mutate and infect those who vaccinated as well as those who are not, being an active market participant is not likely to save you from a disastrous market event as long as you participate in the market.
Instead, the best strategy is having a plan to avoid the mess. If a viral contagion occurred, the best thing to do is leave the crowds quickly and move to a remote area where you can sustain yourself with no outside contact indefinitely. Or at least until a cure is found. If financial contagion occurs, the best strategy may be to leave the market and wait out the disaster until the storm settles.
There are some simple, but not cost-less strategies that can help protect you in a systematic way that requires relatively minimal effort. The first would be investing via the Dual Momentum strategy which I share on this blog. Dual Momentum gets you out of equities when markets decline and into equities when markets rise.
That said, Dual Momentum comes with a very real expense: whipsaws. Whipsaws out of and quickly back into stocks will hurt your returns. During a rising overall equity market, Dual Momentum underperforms the equity index in many years. However, when the equity market experiences a sustained decline, Dual Momentum shines and significantly outperforms equities.
The nice advantage to Dual Momentum is that it’s easy to understand and execute while using low-cost index funds. Even a relatively inexperienced investor can follow Dual Momentum without any trouble.
Another strategy would be diversifying outside of U.S. stocks and bonds as these are most affected by the index trend. Although it takes more work—adding costs in the form of time or fees—investing strategically in safety holdings like precious metals, adding emerging markets and European markets to your portfolio, holding good cash-yield rental properties, and using stop-losses on your positions can limit the downside.
Like everything, I believe this cycle of indexing will subside in the future. There’s always room for indexing, but not everyone can be an indexer. As we've seen in the past, the system will fail when there’s too much money locked into a rigid investing style.
In a perfect world, indexing might be reserved for inexperienced, low net worth investors. Higher net worth individuals and those with experience can participate actively in the markets or pay a moderate fee to someone who can do that for them.
In the meantime, the active fund managers who are lazy and follow benchmarks, as well as the ones who charge way too much money for their services are deservedly going to be purged if this market goes down in an index-driven event.