How Passive Investing Could Change Capitalism

Podcast Summary

• Understanding Index Construction in Passive Investing: Passive investing through indices involves someone making decisions during construction, creating complexity and importance in index selection

  While passive investing through indices has become increasingly popular, it's essential to remember that someone is still making decisions behind the scenes during index construction. The seemingly infinite number of indices available today has transformed what was once a simple reflection of a market into something more complex. This explosion in indices has sparked debate, with some viewing it as a natural progression and others expressing concern. In the following conversation from the Odd Lots podcast, hosts Tracy Alloway and Joe Wasenthal discuss the importance of understanding index construction in the context of passive investing. They highlight how even seemingly simple passive investments require someone to make decisions, and there's an incredible amount of interest and importance placed on index construction as a result. Listeners are encouraged to consider the implications of this trend and stay informed about the ongoing discussion.

• The Evolution of Active and Passive Investing: A Fictional Perspective: Passive investing's rise democratizes access to capital markets, but questions the role of active management and the value they provide. Smart Beta is a response, allowing cheaper access to factors previously only accessible to active managers.

  The shift from active to passive investing over the last decade has brought significant changes to the investment world, with far-reaching implications for both individual investors and society as a whole. Inigo Frazier Jenkins, a quantitative strategist at Bernstein, discusses these changes in a recent research note, which stands out for its unique approach: a work of fiction. Jenkins argues that the relationship between fund buyers and asset managers is evolving, driven in part by the increasing availability of passive investment options. While passive investing has democratized access to capital markets, it also raises questions about the role of active management and the value that active managers can add. One observable market trend associated with this shift is the growing popularity of Smart Beta, which allows investors to buy factors previously only accessible to active managers at a much lower cost. The debate over what active managers should charge for their services is ongoing, with the idea of charging for factor beta being the next stage in this evolution. Smart Beta is expected to be free in terms of headline fees within a year or so. Overall, this discussion highlights the importance of understanding how active and passive investing interact and the evolving role of active managers in today's market.

• Focus on headline fees leads to influx of capital into cheapest funds, but investors should consider real-world outcomes: Investors should evaluate active managers based on their ability to provide net-of-fees returns that outperform real-world benchmarks like retirement and healthcare costs, not just headline fees.

  The focus on headline fees as the primary determinant in fund allocation decisions has led to an influx of capital into the cheapest 20% of both active and passive funds. However, the real outcome that investors care about is the ability to fund retirement, healthcare costs, and other expenses, which are more closely tied to inflation. Asset owners must consider whether active managers can provide a net-of-fees return stream that outperforms these real-world benchmarks. The current landscape of numerous indices and benchmarks has evolved from the simpler days of the Dow Jones index, which initially served as a financial journalism tool rather than an investment benchmark. The proliferation of various indices and benchmarks, including smart beta and factor investing, can be traced back to the need for more nuanced measurements of market movements. Dow and his contemporaries used price-weighted indices due to the limitations of technology at the time. Today, investors must consider the real-world outcomes they desire and whether active managers can deliver on those goals.

• Role and Perception of Indices Evolving from Reporting to Capital Allocation: Indices are no longer just reporting market performance, but guiding capital allocation. Understanding return streams from market beta, factor exposure, and stock-specific decisions is crucial for investors to maximize returns while minimizing costs.

  The role and perception of indices have evolved significantly over time. Initially, they were used to report on market performance, but now, with the rise of smart beta and other factor-based indices, they are increasingly used to guide capital allocation. This shift raises questions about the value of active managers, as investors must consider not just fees, but the net return they receive. With the availability of low-cost or free index funds, investors are forced to reconsider what they expect from active managers. It's no longer enough for a manager to simply outperform a broad index; investors must understand the specific return streams they are paying for. These may include market beta, factor exposure, and stock-specific decisions. The increasing popularity of smart beta and other index strategies underscores the importance of understanding these distinctions, as investors seek to maximize their returns while minimizing costs.

• The Significance of Idiosyncratic Returns in Active Management: In a world where passive investing dominates, managers delivering unique returns add value. However, the focus on fees has led to a trend towards passive and cheap funds, but this may change as investors seek diversification in a lower return environment. The impact of passive investing on market efficiency remains uncertain.

  The importance of idiosyncratic returns in active management has become more significant in today's market, where passive investing has grown significantly. Managers who can deliver returns that cannot be replicated through passive indices offer value to asset owners. However, the focus on headline fees in fund selection has led to a massive flow into the cheapest funds, both passive and active. This trend may change as investors recognize that in a lower return world, bonds and equities no longer offer the diversification they once did. Additionally, it remains unclear if and when the market will become less efficient due to the increasing presence of passive investing. Despite theoretical arguments suggesting this could happen, no one has been able to identify where such a tipping point might be. The Japanese market, where passive investing penetration has surpassed the US level, continues to function, indicating that more passive growth is expected. Identifying a point of mean reversion back into active management is a challenging task and likely far off in the future.

• Market conditions may shift, impacting passive investing: Recency bias in financial research may lead to overreliance on passive strategies, but market shifts and changing asset class relationships could make absolute returns more important.

  The dominance of passive investing strategies in recent decades may not continue to thrive in the face of potential market shifts or changing relationships between asset classes. This is due in part to recency bias in financial research, which has been influenced by the unique market conditions of the last decade, including a prolonged period of declining yields and negative stock-bond correlation. These conditions have contributed to high returns from stocks and bonds, but may not persist in the future. As investors focus on funding real-world needs, it's important to consider inflation as a benchmark for assessing returns and setting hard targets. The focus on absolute outcomes, rather than relative returns, may become more prevalent as market conditions change. Additionally, the idea that passive investing is somehow inferior to other strategies, as suggested in a controversial note, is a complex issue that requires careful consideration of the specific context and goals of individual investors.

• The Importance of Active Investing in Capital Allocation: Despite the rise of passive investing, active investment remains crucial for companies that need capital, secure loans, and pay employees.

  The debate surrounding the role of active versus passive investing in capital allocation raises concerns about the potential consequences of a society where capital allocation is primarily driven by index providers. The author argues that even in a service-based economy, companies still need to raise equity capital, secure loans, and pay employees, making active investment important. Despite the argument not being anti-passive, there have been criticisms that companies may not need to raise equity if growth is coming from services and that passive investment is sufficient for capital allocation. However, the author asserts that active investment remains crucial for companies that require capital, and for those seeking loans or paying employees. The debate also touches on the potential societal implications of a fully capitalized society versus a Marxist one, and the possibility of a "fake capitalist" society where capital allocation is done passively. Overall, the discussion highlights the importance of active investment in the capital allocation process and the potential consequences of a society where this role is diminished.

• Active management vs passive: Opportunities for outperformance: In a low-return world, active managers aim to deliver return streams that fund liabilities by exploiting market volatility, decreased correlation, increased dispersion, and favorable macroeconomic conditions.

  The debate between active and passive management in investing continues, with some arguing that market volatility and correlation between stocks provide opportunities for active managers to outperform. However, the industry faces challenges in restoring investor faith and stopping the bleeding of assets under management (AUM). Active managers believe that in a low-return world, they will need to deliver return streams that can fund liabilities, and this will require a shift towards active decision-making. The success of active management will depend on factors such as decreased correlation between stocks, increased dispersion between stocks, and a macroeconomic environment that allows for more independent bets. Ultimately, the industry must adapt to meet the changing needs of asset owners and provide active return streams to remain relevant.

• Investing in idiosyncratic returns: Asset owners with limited funds for management services should invest in managers generating unique returns not obtainable from cheap factor strategies to maximize value.

  The proliferation of indices and the cheapening of broad market and factor exposure have given asset owners the ability to decide which unique return streams they should pay for. An asset owner with limited funds for asset management services should invest in a manager who can generate returns that cannot be obtained from a combination of simple factor strategies. This concept, known as idiosyncratic returns, refers to returns that are unique to a set of factors that can be bought cheaply. Inigo Fraser Jenkins of Bernstein Research argues that passive investing, which is heavily weighted towards size, may not be the most effective way to allocate capital. This idea raises questions about the stock market and the price signals it sends when they are distorted by indices and massive allocations of capital to the biggest companies. Matt King of Citi has also expressed similar thoughts, arguing that the market no longer self-limits due to the prevalence of passive investing. This conversation highlights the importance of considering the relationship between stocks and bonds and the potential impact of changing intra-asset class correlations on various investment strategies.

• Discussing risk disparity and new podcast launch: Stay informed and engaged in financial matters, take advantage of opportunities to maximize rewards, and listen to the new Money Stuff podcast for insights into Wall Street finance

  Key takeaway from this episode of the Odd Lots podcast is the discussion on risk disparity. The hosts, Tracy Alloway and Joe Weisenthal, highlighted that they have numerous projects underway and acknowledged the existence of risk disparity. They encouraged listeners to stay informed and engaged in financial matters. Additionally, they announced the launch of a new podcast, Money Stuff, featuring Matt Levine and Katie Greifeld. Listeners can tune in every Friday to gain insights into Wall Street finance and other related topics. As a reminder, American Express Business Gold Card offers the opportunity to earn 4 times points on up to $150,000 in purchases per year in the top two eligible spending categories, such as transit, US restaurants, and gas stations. Overall, the podcast episode emphasized the importance of staying informed about financial matters and taking advantage of opportunities to maximize rewards.