In his recent interview with CFA Chile Howard Marks highlighted the impact that passive investing strategies are having on driving stock prices to absurdly expensive levels while also driving out active investors, which keep prices fair. Here’s an excerpt from the interview:
When you see the way the markets have been going. It’s estimated for example that over 95% of all transactions on the New York Stock Exchange are made by machines nowadays, or at least investors who don’t make value judgements.
We’ve had a huge increase in index and other forms of passive investing but when money comes in to an S&P Index fund there’s nobody sitting at the fund who says – the markets too high I’m not going to put the money to work or who says there are 500 stocks I’m supposed to buy but these 50 are too expensive I’m only going to put money in the other 450. They have no choice but to continue putting money in everything in the index for example.
If you and I agreed that over the next five years every penny that came into the stock market would go into the S&P 500 and no money would go into any of the other stocks then it’s clear that at the end of the five years the S&P 500 would be very high in price relative to all the other stocks that languished.
So these passive indices concentrate the money… these passive fund approaches concentrate the money into the things that are defined as being within the target zone and deprive everything outside of money. Now this has been this trend has been working for a long time and the S&P has been outperforming lots of other things and as a result has been outperforming most active investors for a long time.
I think that that will continue to be the case until the things inside the zone are so absurdly expensive relative to everything else that there is no choice but for it to correct. But the trend can go on for a long time before that happens.
Host: I believe that these index funds rely on the supposition that markets are quite efficient and that there’s enough people looking at the markets to see where (inaudible) pricing are so whenever you get money into these funds you have that underlying belief that the things that becomes the market and there is not enough people or other strategies trying to see if to make the market efficient then the market can be these crazy things.
Marks: No you’re absolutely correct and now I know why you are the president of the CFA Society because the passive strategies, if you think about it are the term we use in English, they are freeloaders, they get a free ride based on the efforts of other people.
The assumption is that the active investing community keeps prices fair so that the passive investing community can appropriately allocate its capital based on market values and get an efficiently priced portfolio. But what happens when the assumption no longer holds?
What happens when there aren’t enough people doing active investing to keep the market efficient? In other words I first came upon the concept when I was in graduate school in the 1960’s. The professor explained that the market outperformed most active investors. They said well why don’t they just put money into each of the stocks.
Well that’s a valid approach as long as the stocks are being fairly valued by somebody else but if that person goes on strike then the assumptions deteriorates.
You can watch the entire interview here:
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