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Industry Voices

Commentary: Passive investing – another financial bubble?

A search on "passive investing bubble" returns dozens of links suggesting passive investing might be contributing to high valuations: we might be in bubble territory.

While some valuations are high, it's unclear that passive, or index, investing alone is driving them; easy money and low interest rates are contributing.

Regardless, I am concerned about a potential bubble forming, and the trend to passive investing may stimulate unintended consequences if prices adjust. My unease stems from observations developed after almost a half-century as a professional investor. I've seen more than a few financial bubbles; while they're all different, they share common characteristics. Many of those characteristics are evident today.

Bubble characteristics

The refrain "it's different this time" has often been heard in the investment marketplace. In the late '90s, it was said old metrics — fundamental financial measurements — no longer applied in the internet age; "eyeballs on screens" were more important.

Companies with massive "user" bases saw their stock prices soar, although many were unprofitable. They were being valued as if they would always grow those bases and eventually strike it rich.

Ultimately many companies failed, while a minority have changed the world. Some investors got lucky and bought winners; many lost big chasing trends and ignoring fundamentals.

In his 1963 speech "Securities in an Insecure World," Benjamin Graham, considered the father of value investing, said:

"To my mind, the most valuable contribution that security analysts could make to the art of investing would be the determination of the investment and speculative components in the current price of any given common stock, so that the intending buyer might have some notion of the risks he is taking as well as what profit he might make."

While Mr. Graham's comments were made more than 50 years ago, their wisdom endures. During the technology bubble, the "rules" of investing were suspended as money piled into almost every technology or dot-com company. Today, investing fundamentals have been suspended as money is "directed" rather than "invested" in public equities. So is it really different this time?

Directing vs. investing

There is a clear distinction between "directing" and "investing" capital: to me, passively directing capital is not investing at all. Investing, in the classical sense, presumes a rational case underlies the decision to invest. Passive investing ignores fundamental analysis: allocations are made exclusively on size and liquidity. These factors lack the purposeful intent and informed choice necessary to be "investing."

Indiscriminate allocation of capital is not investing, it's speculation. Rampant speculation has caused financial bubbles.

Lack of fundamental price discovery

In the late '90s, fundamental security analysis was ignored in favor of new, "more important" measures. Today's unprecedented growth of passively directed capital could undermine real fundamental analysis. For any investment professional, this raises concerns about price discovery and stock quote reliability.

If prices decouple from fundamental metrics across a sector or the market, bubble-forming conditions are, unfortunately, all too possible.

As evidence of a bubble, consider that from 1871 (earliest data available) to 2017, the S&P 500 sold for an average 16 times trailing-12-month earnings: today, that figure is about 24. Similarly, the long-term (1871 to 2017) median for the Shiller Cyclically Adjusted Price Earnings Ratio is 16. Today, it's close to 30—almost double. Further observation reveals the ratio was higher only on two previous occasions: 1929 (Black Tuesday) and 2000 (the peak of the dot-com bubble). Does this reveal "bubble territory"?

As professional investors and allocators of capital, we should all be worried when market behaviors are distorting real price discovery. Can we honestly say the shift of more than $1.2 trillion in assets to passive from active management during the past decade (plus historically low interest rates) has not dramatically affected how the market prices public equities?

The extraordinary growth in passive management is contributing to drive high valuations and might be causing a broader decoupling of price and value, which can stoke financial bubbles.

History has shown that all financial bubbles ended when financial gravity inevitably took effect.

In this environment—indeed in all environments—fundamental analysis and discriminate capital allocation should be preferred over directing capital based on a formula or arbitrary cap weight in a benchmark.

Hard to find

Many reject active management because it's hard to pick good managers who will provide alpha going forward. While I don't dispute this, the long-term benefits make it worthwhile.

To find good active managers, I recommend a few prudent steps.

Seek managers with long-term records of sticking to their investment philosophy, and favor those who invest meaningfully alongside their clients.

Evaluate managers over the long term, by which I mean 20 to 30 years or more: and don't change course because of short-term underperformance.

Know that career fears can cause you to abandon otherwise sensible investment plans; therefore, build processes and systems to prevent emotional decisions. Institutions can be subject to the same emotions and behavioral biases as retail investors.

I opened my firm in 1974 influenced by the heady days of the "Nifty Fifty" and the major correction of the early '70s. I also had the great fortune to be mentored by Benjamin Graham, then in the twilight of his illustrious career. In my opinion, his greatest professional contribution to investing was the "margin of safety." Since you cannot know everything about a stock or how markets will behave, you should always seek a margin of safety — a price discount from a stock's estimated true value. This concept captures exactly what is missing when capital is passively directed.

Over the long term, professional active managers have helped create significant wealth by diverging from benchmarks. However, being different can occasionally cause investor anxiety and has perhaps inadvertently supported the ascent of passive management.

My advice, therefore, is this: Be diversified. Don't abandon professional active management. I believe, if or when a passive investment bubble bursts, investors will be glad they had an active manager to help them navigate the aftermath.

Charles Brandes is founder and chairman of Brandes Investment Partners LP, San Diego. This article represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.