"A" is a managing director at a hedge fund, which provides the unique opportunity to obtain insights and perspectives that seldom reach the FIRE echo chamber. "A" has graciously agreed to let me share our most recent correspondence below, which began after I forwarded Big ERN's recent article on the "Passive Investing Bubble."
The big concern I personally have with passive investing is when it's working in concert with unprecedented easy monetary policy.
Global central banks have created an environment of extremely easy money. This interferes with the price discovery mechanism in markets (but especially debt markets). Generally speaking the easier monetary policy, the more that the environment favors growth (momentum) vs Value (low P/E, stable earnings).
Favoring the growth factor over the value factors is not necessarily a bad thing. In many ways it represents the progression of our society. Many of us prefer to invest in technological growth vs traditional value based companies (manufacturing, commodity, food, energy, etc.).
The problem is that the more extreme monetary policy becomes, the more that active investors are forced to disproportionately chase the growth factor valuation vs the value (stable earnings factor). This occurs for a variety of reasons, but to simplify lets just make the assumption that being able to borrow money cheaply is rocket fuel for growth oriented companies, and does not really help companies with already stable earnings streams.
Where passive comes into this is that the indices are designed to follow the flow of active investors. As monetary policy has continued to get easier and easier, we see massive outflows from value factor and into growth factor.
Value factor earnings growth tends to be correlated to rising interest rates and tighter monetary policy. So in the world of prolonged zero interest rate policy, we end up in a situation where the most common passive indices are very top heavy to growth factors (that trade at lofty valuations) and have less exposure to traditional companies that have more steady earnings. This over time will expose the passive investor to more volatility (March 2020) and also into a risk profile that does not follow the traditional earnings expectations.
Many assumptions are made based on historical returns, that over time stocks can be expected to earn x% annually. Those expectations were all formulated and based on historical representation of value factors (stable earnings) having a higher weighting vs the environment we are in today. As I watch the index rebalance events unfold and see record selling in extremely "cheap" stocks, and record inflows into "expensive" high growth potential stocks-- I see the writing on the wall for a future where people do not understand why the past x% annual return is not being represented appropriately.
If we make the assumption that monetary policy will be easy forever, then the lofty valuations of growth/momentum focused indices of the present can probably be maintained. Should there be any bump in the road that causes global central banks to scale back into a more hawkish policy (i.e. inflation) there will be a "shock" re-valuation. Now these shocks always happen (as the article you linked me to discussed) and they are part of the business cycle. But one has never happened when the majority of passive money has been allocated to a less traditional factor profile that is way over allocated towards high valuation growth.
As you are aware, passive investors are not forced to allocate this way. There is a tremendous variety of what an investor can do. The problem is that most passive investors are following traditional indices, under what I think is a false expectation that they are being exposed to a mixture of traditional earnings type stocks and some growth (high valuation stocks). The reality is that the makeup of the largest and most popular indices have never been more weighted towards growth, and have never had less exposure to value. We are not even close to the previous extremes. Looking at historical growth vs value factors we are currently in a black swan environment on the factor side.
I read some crazy statistics the other day, that the amount of stock that Apple has bought back (share repurchases) is bigger than the market cap of 482 of the companies in the S&P 500. The S&P500 has really turned into the S&P 5. The same goes for some of the big MSCI indices, etc. Now as we see stories about how Tesla is trying to make its way into the S&P500 one has to wonder how extreme this shift will get into lofty growth valuations as the primary vehicle of investment.
I see many of my coworkers and colleagues at big banks completely throwing in the towel in the last few months. Nearly everything one has learned on how to construct a portfolio, how to value stocks (CFA) has been thrown out the window. I definitely do not think passive investors caused this or played any role in propagating this. Global monetary policy has been too easy for too long, creating excess cash and the TINA (there is no alternative) problem.
Let us hope that we avoid some unforeseen circumstances that should cause central banks to tighten (i.e inflation). If that happens the big indices will no longer be diverse enough to protect passive investors from large and sustained losses. The catch 22 of all this is that the central banks know this, and therefore they are stuck in an impossibly difficult position. Keep pumping easy money into the economy and risk causing the asset inflation problem to get worse, or scale back monetary policy and destroy the S&P 5.
So there you have it, my fellow passive investors. Some refreshing perspective on our current era, and the vulnerabilities of our shared investing strategy.
Thanks, "A," for ensuring we continue our investing journey with eyes wide open.