Active managers are just imagining an index bubble
Spoiler alert: Index funds are no bubble.
It’s not terribly surprising that active managers loathe index funds. It can’t be pleasant to watch their time-honored craft reduced to a computer program and sold for a pittance. Some managers have fought back by accusing index funds of promoting monopolies and distorting markets, among other horrors, but it hasn’t stemmed the wave of money flowing to index products.
Even Jim Cramer, TV’s most famous stock picker, has been converted. He recently confessed on his show “Mad Money” that “I have not ever point-blank warned you off individual stocks, so let me do so tonight. I would actually vastly prefer you to invest in index funds than to be, say, in mutual funds.”
Still, active managers could take comfort in the fact that more money was entrusted to them than their indexing nemeses — until now. As Bloomberg News reported last week, assets in index-based U.S. equity mutual funds and ETFs topped those run by stock pickers for the first time in August. After accounting for last month’s fund flows, Morningstar estimates that $4.271 trillion is invested in U.S. stock index funds, compared with $4.246 trillion in those run by stock pickers.
The activity began last Friday when 6.4 million shares hit the tape, fueling a record daily inflow for the fund.
The new data will allow retail investors to better compare active and passive funds.
Active managers still oversee more money in bonds and international stocks, but their results are no more flattering than those of U.S. stock pickers, so it’s only a matter of time before index funds overtake them, too. According to the latest SPIVA scorecard, 90% of actively managed international stock mutual funds and 96% of emerging-market ones lost to their benchmarks over the last 15 years through 2018. The overwhelming majority of bond funds also failed to keep up with their benchmarks over the same period.
Facing an existential crisis, active managers are now trying to scare investors out of index funds by hanging the dreaded B-word on indexing. Hedge fund manager Michael Burry, hero of “The Big Short” who made a fortune shorting the housing market before it imploded in 2008, called indexing a bubble in an interview with Bloomberg earlier this month, just the latest money maven to do so.
It’s a frivolous claim because index funds are merely a vehicle, not an investment per se. It’s like calling brokerage accounts or safe deposit boxes or wallets a bubble — it’s not the container that matters, but what’s inside it. Index funds track a wide range of global investments, including stocks, bonds, real estate, commodities and currencies. Surely not all of them are bubbles.
There’s no single definition of a bubble, and it’s difficult to spot one without the benefit of hindsight, but they’re commonly characterized by a buying frenzy that results in an unusual surge in prices. Think cryptocurrencies in 2017, when Hodlers bid up the price of Bitcoin 24-fold in one year. While it’s hard to think of any investment tracked by index funds with a comparably meteoric rise, it’s easy to think of ones that investors are avoiding, such as financial and energy stocks in the U.S. and many stock markets around the world. The fact that index funds track those markets hasn’t made them any more appealing.
So when Burry and others call indexing a bubble, I suspect their primary complaint is that investors are blindly pouring money into index funds that track the broad U.S. stock market and are thus propelling it to lofty levels. U.S. stocks are not cheap, and by some measures the market has been this expensive only once before, during the peak of the dot-com bubble in 2000.
There’s little evidence, however, that active managers as a group are any more discerning than indexers. By conventional measures, U.S. stock pickers are paying just as much for stocks. I counted 5,204 actively managed U.S. equity mutual funds, including their various share classes. Their average price-to-book ratio is 3.4, according to Morningstar data, compared with 3.2 for the broad-market Russell 3000 Index. Their price-to-sales ratio is 2.2, based on last year’s financial results, compared with 2.1 for the index. Their price-to-earnings ratio is 21.1, compared with 21 for the index. And their price-to-cash flow ratio is 13.9, compared with 13 for the index.
It’s not as if stock pickers have no choice. On the contrary, they have many opportunities to hunt for bargains if they, like Burry, believe that indexers are overpaying. The difference in valuation between the Russell 3000 Growth Index and the Russell 3000 Value Index, as measured by their P/E ratios, is higher today than at any point since 2000. The same is true between the Russell 1000 Index, which tracks large and midsize companies, and the Russell 2000 Index, which tracks smaller firms.
But shopping for cheaper and smaller companies would mean straying from popular broad-market gauges like the S&P 500, which are dominated by larger firms and packed with expensive growth stocks. Few managers have the stomach for that because clients get annoyed when those gauges soar and their portfolios fail to keep pace. As legendary money manager Barton Biggs reputedly warned, “Bullish and wrong and clients are angry; bearish and wrong and they fire you.”
Burry is probably right that many U.S. stocks are too expensive, but that’s no fault of index funds. There’s plenty of blame to go around, starting with the stock pickers.