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How passive investing’s focus on momentum rather than value kills real economic growth

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The core purpose of the stock market is to allocate capital to good companies. Of course, we use it for our own benefit, whether it be retirement planning or speculative day trading. There are a lot of individuals who don’t want to make any stock investing decisions, and instead, just want an easy low-fee index fund. It has come to no surprise that index investing is one of the biggest innovations in financial history.

Buying momentum rather than value

The FAANG stocks are the story of the past decade, and now make up approximately 20% of the S&P 500. The incredible rise in share price is partly due to growth, but primarily due to momentum. This is because nearly 50% of the ownership comes from index funds and ETF’s. These indexes are usually cap-weighted, meaning that short-term winners will receive more investment.

Funds are buying more expensive stocks that rise to higher valuations. There’s a disregard for the underlying fundamentals now. As an investor, that presents opportunities, which we will discuss at the end of the article.

Three firms soon to hold >50% of shareholder rights

But first, think about the fact that indexes now account for half the ownership. You might think that there’s a major risk to the fact that half the S&P ownership is in the hands of 3 firms (Vanguard, Blackrock & State Street), and you are right. John Bogle, the founder of Vanguard, even agrees on this aspect (his WSJ article is linked here). The concentration of control is at a dangerous level. Simply introducing new fiduciary responsibilities with higher/accountability and penalties won’t be enough, nor will any other proposed method.

The Financial Times recently published an article focused on the regulatory actions for this risk factor. Nonetheless, this is not our primary concern.

The great liquidity bust, what could happen?

The risk is in liquidity. Indexes and ETF’s were great when they accounted for 5% of the ownership, not 50%. If an index or ETF is being aggressively sold by the market, it will lead to a fire sale of the underlying securities. Like many stocks, partly thanks to indexes, are fueled by artificial demand: they will plummet even faster.

Source: Forbes

“This creates a piling-on effect as funds buy more of these increasingly expensive stocks and less of the cheaper ones in their indices — the polar opposite of the adage “buy low, sell high”. Risks of a bubble rise when there is no regard for underlying fundamentals or price. It is reasonable to assume a sustained market correction would lead to stocks that were disproportionately bought because of ETFs and index funds being disproportionately sold.” Financial Times

Let’s not forget that the holy grail of investing is to earn a good long-term return with minimum volatility.

Active or passive? Or what?

The Harvard Law School Forum on Corporate Governance and Financial Regulation recently published an article highlighting the 4 ways in which the active-to-passive shift may affect financial stability. You can read that here.

Active management is often called a bubble, but it does bring various benefits. It generally increases the quality of stock analysis, and as a result, the value of specific companies is priced more accurately (relative). Many active managers have underperformed the market while charging high fees, which of course is not a great solution either.

If you’re a retail investor, it often is better to manage your investments directly.

Conclusion

The final conclusion will always be that momentum can not buy permanent alpha. Capital should be allocated to good businesses with a good ROIC, and not according to the swings of the market capitalization of the underlying companies of an index.

The table below shows a list of fund managers with a minimum of $10 billion under management that explicitly expressed their concerns about passive investing and the use of ETF’s.

Value investors critical of passive investing

Source: Twitter

Bonus Tip

As mentioned in the earlier part of this article, we would not leave without a recommendation. We actually give you two.

Due to the index’ focus on larger companies, a lot of great value opportunities are present in the small-cap market. You might have to look beyond the US as well to find the best opportunities.

Another idea is to search for active managers that got slammed for being active managers. Their stock prices are hurting, but a lot of them have massive cash holdings right now. Multiple of them have cash positions that exceed half their market value. This will provide a limited downside risk.

An example of this is Franklin Resources. This stock is owned by David Abrams as well, one of the best value investors of our generation.

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