Passive Investing's Bubble Innovation

How this financial innovation risks another investment disaster...

IF THERE's one thing that history teaches us, writes John Stepek, executive editor of MoneyWeek magazine, it's that financial innovation and eventual disaster go hand in hand.

This makes intuitive sense. It's just the way of things.

If a system or process produces positive results, then it will continue to be pushed harder and harder until it hits its breaking point.

So which financial doomsday device is currently driving the markets towards a deadly denouement?

Why, it's our old favourite, passive investing.

Financial innovation has played a role in pretty much every big bubble you can think of.

In the bubble of the 1920s in the US, the new financial technology was investment trusts – companies set up purely to invest in other companies.

Investment trusts themselves are great. We love them. They're one of our favourite investment vehicles. But back then, this new financial technology was used and abused to well beyond breaking point.

Investment trusts used plenty of borrowed money, bought shares in other trusts, merged with other trusts, even bought their own shares (which is utterly crazy if you think about it for just a moment), and were rife with insider trading. So when things went pear-shaped, they toppled like dominoes.

The 1987 stockmarket crash (which was huge, but relatively unimportant in the long run) was driven in large part by a financial innovation – "portfolio insurance". Basically, this was a computerised trading innovation designed to hedge a manager's position during downturns. Instead, everything went wrong, it amplified the sell-off.

And our most recent epic financial catastrophe, the 2008 crisis, was fuelled by the financial innovation of securitisation – bundling up home loans and flogging them off to yield-hungry investors. A variation on cross-holdings was involved too – "special purpose vehicles". These were ostensibly separate from the banks that set them up, but which in fact ended up being the banks' problem when they went spectacularly wrong.

Of course, there were plenty of other factors involved in all of these crashes: usually you have plenty of borrowing, and often you have an era of optimism triggered by a revolutionary non-financial technology of some sort. My point is just that successful financial innovation is often a necessary ingredient too.

So what's today's big new financial technology? Index investing, of course.

Investors across the globe – but nowhere more so than in America – have discovered the joys of "beta". Why pay an expensive fund manager good money to hunt for "alpha" (market-beating returns) that they probably won't find, when you can get "beta" (the market return) cheaply and predictably?

It's taken a while for the passive gospel to spread. I remember writing about how wonderful exchange-traded funds (ETFs) and trackers were back in the early 2000s. But now it's turned into a wildfire, burning up the business models of the fund management industry. As Bank of America Merrill Lynch point out, over the last 12 months, investors have pulled money out of active funds (on a net basis) every single week, until the start of this month.

Already, passive investments account for around 28.5% of global assets under management. At the current growth rate, says credit ratings agency Moody's, passive funds will overtake active ones (in the US at least) by as early as 2021.

And now it seems that this epic switch to passive investments is helping to fuel the overvaluation of US stocks.

Financial Times columnist John Authers explains why in his latest email. Active funds hold at least some of their portfolio in cash – 3% on average in the US. Passive funds don't. Pretty much all of the money goes into the market. So even if I take $10,000 out of an active stockmarket fund and put the same $10,000 into a passive fund, there will be more money going into equities than there was before.

In other words, even if the investors flooding out of active funds and into passive ones are simply being sensible, and replacing closet trackers, then it still adds up to a significant amount of extra money going into equities every month. And that's why, "at the margin, the shift to passive helps to push the market up".

That helps to explain why US stocks in particular seem unstoppable, even although they are already overvalued on almost any objective measure.

Stick with passive – but make sure you know what you're buying

So does this mean that passive investing is a problem?

Of course not. Passive investing is a good thing. As I've said countless times before, for many private investors it's just a cheaper way of accessing the same sort of performance they were already getting. As with bubbles of the past, playing a role in driving the market higher doesn't make a financial technology bad in itself.

But it is a useful reminder that, as with any other investment, you need to know exactly what you're buying. It's a good idea to look at passive options for any market you want to invest in. They're cheaper, and you know what to expect. But there's no point in buying a cheap fund that's tracking an expensive market.

So buying an S&P500 tracker makes no more sense than buying an actively-managed fund that's benchmarked to the S&P500. At the end of the day, if US stocks are overvalued and they're going to go down, then both passive and active investors in US stocks will lose out.

Similarly, if you are buying an index fund, make sure you know what the index holds.

For example, I've always found the South Korean market vaguely interesting. But buying a tracker fund that follows the Kospi (the South Korean benchmark index) doesn't appeal to me, because almost a quarter of that particular index is taken up by smartphone giant Samsung.

Samsung isn't a bad stock by any means, but that sort of tracker is not exactly giving you diversified exposure.

Don't get me wrong. I fully expect passive funds to be accused of all sorts of things when this particular bull market ends in tears, mutual recriminations, and the flinging of suitcases full of clothes out of the window (or something like that).

But I'm sticking with passive. I just won't expect it to somehow work miracles on markets that are already too expensive.