Odd Lots - How Passive Investing Could Change Capitalism

Episode Date: December 17, 2018

The biggest macro trend in investing is the rise of so-called "passive investing." But while this may have advantages for the individual investor, it raises a whole new host of issues, such as elevating the role of index designers, and decreasing the emphasis on studying individual companies. On this week's Odd Lots podcast, we speak with Bernstein's Inigo Fraser-Jenkins who once wrote a note that said passive investing is "worse for society than Marxism."See omnystudio.com/listener for privacy information.

Thanks for listening to Oddlots. Follow the show on Amazon Music for more future episodes or just ask Alexa, play the podcast, OddLots on Amazon Music. Hello and welcome to another episode of the Odd Lots podcast. I'm Tracy Allaway. And I'm Joe Wisenthall. So, Joe, we've talked before on this podcast about passive investing, right? I seem to remember that. I'm sure we must have. In fact, are there any other types of investing anymore? If we talked about investing, I'm sure we talked about passive investing. No, you're absolutely right. But I'm trying to think now, I guess that means we haven't talked about the sort of basis of passive investing, which is index construction, right? If you're going to invest passively, you need to be investing essentially in some sort of index or benchmark.

Exactly right. So you could say, oh, I'm not going to make any choices in my investment. I'm just going to invest in the market. But even that has to have some definition. If it's the S&P 500, then whoever designs the S&P 500 is ultimately the one constructing your portfolio. So ultimately, someone is making a decision even if you think you're sort of trying to take human discretion out of the process. Right. And there's really been an explosion in all types of indices recently, sort of growing in tandem with the big growth that we, we've seen in passive investing in general.

One thing that gets bandied around quite a lot is that there are now more indices in the world than there are individual stocks, which, you know, stop and think about that for a moment. It's pretty amazing, although I guess, you know, you could say, given the amount of stocks available in the world, there's sort of an infinite number of combinations that you could get at that point. But it does suggest that something that was supposed to be a simple reflection of a particular market has sort of morphed into something else. Right. I think Bloomberg's Eric Belcuna's had a really interesting column this week,

pointing out that, you know, there's only really 12 notes on an octave, but there's hundreds of millions of songs. And I think that's a pretty good analogy for the relationship between individual components and indexes. And of course, there's essentially an infinite number of ways that you can arrange them and weight the components and weight them by size or factor or whatever. So it's not surprising that there is an incredible amount of interest and importance placed on index construction these days. Right. And people's thinking about this indexation kind of issue or explosion in indices, it tends to

either be of that sort of ilk where people think, oh, well, it's natural that this is happening because we have these different varieties of indexes that you can build using different types of stocks. But there's another extreme end of this. And, you know, people who actually find it quite worrying and quite dangerous for one reason or another. And today, we are going to be speaking with someone who is firmly at that end of the discussion. I can't wait. This is a really important topic. I joked in the beginning that is there any other type of investing besides passive?

because it really does feel like that is swallowing everything. And I think there's a real existential question about the role of what used to be called discretionary investing. And so I think there's, it's a great, it's a great timely and timeless topic for us. Yes, indeed. All right. So without further ado, our guest for this episode is Inigo Fraser Jenkins. He is a quantitative strategist over at Bernstein. You may remember him, listeners, as the guy who wrote The Silent Road to Surfdom,

why passive investing is worse than Marxism. So I promise this is going to be an interesting discussion. Inigo, thank you so much for coming on. Thank you for having me on. So, Inigo, I guess my first question is you've written quite a few notes about indexing at this point in time. Your latest one is sort of unusual in the field of analyst research. You know, it was called Fund Management Strategy, the man who created the last index. And it's sort of a fictional slash historical look at index creation.

How did you focus on this particular topic? Yes. So when we think about the way investment works at the moment, I think this $5 trillion switch from actor to passive has taken place in last decade is one of the biggest. changes that we've seen, and I think that passive has a lot further to grow. I think that some people have interpreted some of our previous work, because that's the one you just mentioned earlier, as us being anti-passive in some way. I wouldn't describe myself as anti-passive, because passive is done more to democratize access to capital markets than any other invention in investing in the last couple of decades. But it does change the calculus for investors, both at the

micro-level for an individual investor and for society overall. And so for an individual investor, there's a question of how active and passive interact with each other in their overall holdings for society overall, their big implications for capital allocation and for stewardship. And I think that what this all comes down to is the relationship between a fund buyer and an asset manager is changing and has further to change, and that's been driven to some extent by the increase in passive options that are out there. Now, you mentioned, we've written about this in research notes in the past, we want to do something a bit bit different here by writing a work of fiction. I mean, firstly, hopefully it's a bit more fun.

It allows us to use kind of language as not possible in a normal style-side research note, but also allows us to approach the active, passive split from a few different perspectives. Where do you see this showing up? So it's one thing to talk about changes in governance. It's another thing to talk about changes in capital allocation and how. that goes about. But when you look at the market, you still see some stocks doing well, you still see some stocks doing badly, some companies thriving. Can you point to something happening in the market that's sort of independently observable and say, okay, here is a change in the way markets

behave that we can associate with all the money leaving active and flowing into passive? I think the biggest issue here is just, it's a question of what an investor expects to get out of an active manager. And I think we've seen some myths been some blown up about that in the last decade or so. So the idea that one could charge for beta, as an active manager, has been obviously debunked some time ago with the role of passive broad index funds. I think the next stage really is the idea of charging for factor beta, in a sense, active managers who are actually just consistently hugging some factors in the market. and now you can buy those factors.

The current going rate is four basis points. I think Smart Beta will be free within a year or so, at least in terms of headline fee, if nothing else. And so that really kind of focuses attention on what the point of an active manager is. And so I think that's where the biggest change comes here. I think there's been perhaps a mistaken belief that because it's very easy to measure headline fee, that has become the key determinant in so many fund allocation decisions. And when you look at the allocations both within active and within passive in the last few years, more than 100% of the net flow has gone to the cheapest 20% of active funds and the cheapest 20% of passive funds.

Now, on the one hand, that's great and it's allowed asset owners to lower their overall cost of employing asset managers. But headline fee only really matters to the extent that it influences the quality of the net of fee outcome. And I think that there needs to be a focusing on the minds about what kind of outcome people want from investment decisions. And this sort of fits into a much bigger picture, which is the last 35 years, equities have gone up, bonds have gone up, and they've managed to do so in a way that's given a negative correlation between them. So an extraordinarily benign set of circumstances. And that has at least been part of the reason why, at least with hindsight, has made sense for people to, allocate from active to passive. I think that if one projects forward from here and says, well, there are a number of reasons to suspect that we might be in a lower return world across

asset classes. And it raises the question of, well, what is the outcome that people want? What is the real benchmark that investors care about? That real benchmark probably ultimately comes down to trying to fund retirement, healthcare costs, school fees, etc. All those things trade more like CPI than like a capital market return. The question is, can asset owners come into active managers and buy a return stream the net of fees will beat that? That, in my mind, is an active decision, but it's been somewhat subsumed by everyone assuming that the right thing to go and do is to hire a series of active managers who can perform relative to a very specific benchmark and a series of pigeonholes across the market.

So could you maybe step back for a second and describe how we got from, you know, a sort of a relatively simple or simpler place where we had the Dow Jones Index? I mean, when the Dow Jones Index was invented, it had, I think, something like a dozen stocks in it. And now we're at this place where we have hundreds, if not thousands of different indices and benchmarks of all different types and flavors, smart beta, factor investing, whatever you want to call it. how did we actually get here? Yeah, so in the background to doing this note was spent some times reading the early work of Dow and Poor, and it's kind of fascinating to see the motivation behind the work that they did. The work of Dow and Poor was firmly in the camp of financial journalism, not in the camp of investing. So people may complain about price-weighted indices, but it was perfectly sensible decision for Dow if he wanted to report.

report on the movement of the market the day before, simply to add up prices and divide them by the number of stocks that he was using, apart from anything else, without modern calculating machines, it was hard to do that work any other way. And that was a fair way to give a sense of broad market movements. You can go back before that to the work of poor and his work on the history of railroads in the US. It doesn't seem like one's reading. a work of an index constructor when one picks up that book. But I would argue that one is because he has this massive enumeration of facts, which in this case are miles of new track laid each year and dividends paid by railroad companies. And it's basically a prose version of an index, I would argue.

I guess as one roll the clocks forward, the question of indexing became kind of critical for solving the agency problem, which is always inherent if one goes out and hires an asset manager to run assets for you. How do I know I'm getting good value for money from this asset manager? How do I know they're doing something for me that I couldn't get more cheaply somewhere else? And of course, that's become a very broadly embedded as the idea of needing to outperform a broad market index, and that's driven the initial role of passive. But once one accepts that idea that an index could be a rules-driven approach to selecting kind of companies, as you said in your introduction to this piece, then suddenly the possibilities are endless.

And who's to say that a given definition of a broad index is the benchmark that people have? And there are a massive number of other ways of doing that. The question, I think, then becomes confused about whether one is right in a given circumstance to get rid of an active manager and replace them with a passive manager, which that would be the right thing to go and do if that active manager was doing nothing other than hugging a passive index. But that gets confused with a broader question of, well, what is the end outcome that people want to have?

And I think there's been almost a inversion in the direction of causation, if I can say that, in the way people think about indices. The initial indices were there to report on what had happened in the market. at the day before, now the construction of new indices, particularly some of the smart beta indices, are actually directing capital allocation and become essentially a forward-looking going to guide to where equity capital goes. Right. I think about this a lot.

So, you know, we're talking about smart beta. So for people who aren't necessarily familiar with it, this idea that there are factors within stocks that by some sort of researchers have. have characterized outperformance, whether it's stocks that are cheap on a PE basis or stocks that exhibit high levels of momentum, things like that. And so this idea is that, well, why not just invest in an ETF or an index that captures all those things and you don't have to do the work? One thing I wonder about is like, okay, you make an interesting and important point that the issue for investors shouldn't be fees per se, but that return net of fees. That still raises the

question of that, even if there are active managers who can deliver superior performance net of fees, does the individual investor have any way to identify them? I think the investor needs to be clear about what kind of return stream they want from their active manager. So I think it's normal for people nowadays to think about a manager has been a good manager if they deliver a return that exceeds that of the index. But of course, if one goes to a manager, one's buying a whole bundle of return streams all wrapped together in what their fund produces. Some of that's new market beta. Some of it will happen to be factors, as you outlined just earlier in the form of smart beta. Some of it will be very stock-specific decisions that the manager has made. I think the one really

important changes happening is by smart beta or these simple factors, essentially becoming free or something close to that, it really focused attention on what one should get out of an active manager, because it's always been possible for more sophisticated investors, say, to disentangle the kinds of return streams that they've had from the fund manager. But it's been much harder to do that more broadly across the whole. base of fund buyers. And now one can buy these factors essentially for free, a very important distinction gets made. And one can say, well, it is this manager giving me a return stream that is idiosyncratic, I is different from this set of factors that I can buy? I think that's an

enormous important development because it allows us to say which kind of return streams become genuinely valuable for the asset owner, return streams you cannot get from simply holding a static combination of factors. So I'd argue that actually with the cheapening of indices and the growth of more indices, maybe ironically it's actually made it much easier perhaps to now identify what one would want from an active manager, and that is idiosyncratic returns. Why is that not more reflected in flows into active management then? Because, you know, this is the discussion that comes up all the time with the explosion of passive investing. Most people would say, well, eventually passive investment is going to misdirect capital or misallocate capital and there's

going to be big price discrepancies that active managers can come in and exploit in some way, maybe by producing, you know, idiosyncratic or specialized returns, as you put it. Why aren't we actually seeing that play out in the market then? Yeah, I think there are a few reasons that. I mean, I guess the initial answer is that the entire focus of fund selection seems to be overly focused on headline fee. I mean, it's obviously very easy to identify headline fee up front ahead of time. And as I said earlier, that has meant there's been a huge flow into the cheapest funds, both inactive and within passive. I guess another reason is that if one goes back 10 years, then yes, it's true. there were too many active investors who were charging an active fee for delivering something

that was very close to the index, and it's right that someone has created a series of passive indices and taken capital from those managers. I think where it gets more complicated is that, again, as I mentioned earlier, this has been an environment for 30, 35 years when, with hindsight, having a passive long-only exposure to equities and a passive long and exposure to bonds has been not only good from a return perspective, it's beaten CPI, but they've offered a diversification between them. To go back of a longer horizon, that diversification is actually quite unusual. So I think that some of the support that passive has had has been a matter of circumstance and where we happen to have been from a macro

perspective for the last few decades, and that's going to evolve. But now inevitably, it'll take time for people to realize that we're in a new lower return world where bonds and equities aren't diversifying, that will take some time to be more broadly recognized. But when it does, it does change the calculus between active and passive investing. Also, the other thing I would just pick up on is your point about this discussion around, does the market become inefficient in some way when there's so much passive that it creates perhaps unusually good opportunities for active managers. Well, I mean, in theory, we can say that that's the case.

I think in practice, it's very hard to identify. To my knowledge, no one has managed to theoretically identify where such a limit might apply. We don't even know if the relationship between the amount of past investing that exists in the market and the efficiency of the market is something that is a linear thing that simply gets worse and worse over time, as passive gets larger or whether there's some as a tipping point.

But we can say is the case of Japan, where the penetration of past investing has gone way beyond the 50% level that the US has got to, and the Japanese market is still functioning. So I think we can say that we should expect more growth in passive to come, and that to identify a point at which there is, where we should expect a mean reversion back into active, I think is very hard and something that's very far off in the future. Canadian women are looking for more. More to themselves, their businesses, their elected leaders, and the world are out of them. And that's why we're thrilled to introduce the Honest Talk podcast. I'm Jennifer Stewart. And I'm Catherine Clark. And in this podcast, we interview Canada's most

inspiring women. Entrepreneurs, artists, athletes, politicians, and newsmakers, all at different stages of their journey. So if you're looking to connect, then we hope you'll join us. Listen to the Honest Talk podcast and IHartRadio or wherever you listen to your podcasts. I thought it was very interesting what you said about our faith in passive strategies as being somewhat dictated by the backdrop of markets over the last few decades and the inverse relationship between stocks and treasuries. I think it is the same point made in our recent discussion with Chris Cole of Artemis Capital about expectations of volatility. I think it's been a consistent theme on this podcast. I mean, Tracy said at the beginning, have we talked about passive? And we definitely have.

But I do think that a consistent idea that we've heard a lot of people discuss from a lot of different angles has been this question of whether investors have been lulled into thinking that there's some strategy that's clearly the best strategy, but that it's only the best strategy. but that it's only the best strategy, in fact, because of the certain behavior of markets over the last few decades, particularly the relationship between stocks and bonds that has made that the best strategy. So I'm curious if you could expand more on that and talk about why the way a lot of, you know, maybe individual investors or more sophisticated investors have their portfolios constructed, why passive strategies may not thrive if there is a regime shift or if there is a relationship shift between asset classes. Yes, I think there's a lot of recency bias, which is hard to avoid for good reasons in a lot of finance. research takes place. I mean, I guess we could point to the last decade of a QE-dominated environment as giving rise to a series of interactions in the market that might not be normal, and as that comes to an end, they may change. I think there's also a residency bias in the longer on which of the period since the early 80s has been one of declining yields across asset classes.

So equity yields have come down, bond yields have come down, there's been asset price inflation. At the same time, inflation has come down as well. That's contributed to returns from stocks and bonds being much higher than returns are required to beat inflation and this negative stock bond correlation as well, which is unusually. If you go back over a couple of centuries, you don't normally see negative stock bond correlation, normally that's a positive number. And so I guess to try and put in perspective how important that is, one again comes back to the question of why people are trying to invest. And I think they're trying to invest to fund needs that they have with the set in the real economy.

If they're set in the real economy, it's more likely that inflation is a better benchmark for people. And so when people want to assess to return from a strategy going forward, I think it's more likely that people are focused on inflation plus. as a benchmark, or thinking of absolute outcomes, so a guaranteed outcome or a hard outcome target, such as 5% or 6% as being a return that people should expect. Now, that's not to say that I'm bearish on the stock market. It does not require stocks go down to focus people's minds on the market in this way, But from a Shillip E. in the low 30s, it does strongly imply subpar returns many years in the future. I briefly mentioned this in your intro, but I'd be curious, you know, the note that you wrote why passive investing is worse than Marxism, that got a lot of attention at the time and certainly cropped up in a bunch of different financial media.

What was that like for you? Like what sort of feedback did you get from clients or readers? And maybe even you got some backlash from index providers. I don't know. What was the reaction? Yes, certainly I'm surprised by the scale of the reaction, I have to say. I think the feedback I got, for many people, was that this was a topic that people were concerned about. And it often falls between the planks of the way the research is conducted, certainly in terms of reaching on the south.

side, people don't normally write about business strategies on the by side. And so I suddenly spoke to a lot of the concerns that people had. I think also it found some agreement from people in asset management companies who have been trying to engage with policy makers and try to make the case that there are some strategic issues at stake here aside from the the more specific issues around an individual fund and whether an individual asset owner should buy an active or passive fund in that particular case. Maybe you can just sort of quickly summarize your argument, because in talking to you so far, as you said, you're not really anti-passive per se, and you point out that we don't know

where the tipping point would be that in Japan, the share that goes to passive is much higher than it is here and the Japanese market still more or less function fine. So for those who haven't read your note, which is most people, what does that mean worse than Marxism? How would you describe it? And I would not be surprised if the media distorted your argument in some way. Well, the argument is quite a simple one, which is simply to think about how capital is allocated in society. So the worst of Marxism is definitely not from the point of you of an investor. It's from the point of view of society of rule and the role of capital allocation in society. So it's not about investment outcomes per se.

And one can think about three different possible types of society. One, a fully capitalist society where people make very active asset allocation decisions, another a Marxist society where someone is given the job centrally to plan how capital is allocated. And then a third possibility, which would be a sort of fake capitalist society, if you like, in which the capital allocation is done on a sort of passive trailing basis. So companies that have done well simply are accorded bigger weights and equity indices. And I guess the pushback on it, there have been various forms of it, but one of the main forms of pushback was the idea that

do companies actually need to raise equity if we're in a capital-light economy, where the growth especially is coming from more service-based industries, how important, is the capital allocation process from active investors. And I'd argue that it is still important. I mean, A, because there is still a range of corporates in the market that do need to raise capital. Secondly, even if a company is not raising equity capital, often they want credit or bank loans, and that becomes cheaper if they have a share price that reflects all their information. And thirdly, they want to pay employees often through stock, if that's possible.

So is the argument that basically capital is being allocated in a way dictated by index providers? Well, merely to make the point that as new kind of capital and is invested, there are reverse ways of thinking about how that is directed to corporate. And one can either take a very active decision to say, well, a certain company has certain growth prospects determined by its fundamental outlook or its role in society overall and accorded to certain evaluation and allocation of capital accordingly, or else it is simply grown to be a certain size of a market and therefore as new capital comes in to an index, that that company is simply accorded extra value purely because of the size it's reached in the index

already. I want to ask about what it will take for active management to make a comeback essentially and for managers to convince investors that there's more to life than just the upfront fee. And something I've been thinking about this year is that we have had these periods of volatility in which the relationship between stocks and bonds that we've been talking about has not, in fact, held up the way people might have experienced. whether it's the February volatility or volatility this fall. And yet, when I look across the landscape, I don't exactly see active management appearing to have done all that well, to be honest. And I know that, you know, it was a pretty brutal month for many hedge funds. I think November

was pretty awful for them. So, A, I'm curious, why haven't we seen this year more examples of active managers saying, aha, this is what you pay us for because we can deliver in times like this, and then be just what the general strategy will be for the industry to not keep bleeding AOM. Yeah. So I think it's certainly apparent from conversations I've had with active managers over the last few years that a few people have taken the view that what we really need is a big drawdown in the market and that will separate active and passive.

My response has always been, we'll be really careful what you wish for because the 2008 period was not a happy one for many active managers. So I'm not sure if that is something that active managers should wish for. He's not in the short term anyway. I think there is something that can be said about the potential for active outperformance and the structure of the market. And by that, what I mean is the performance of active managers tends to depend on how many independent bets they can put on in their portfolio. that in turn is a function of how correlated stocks are. And we happen to have gone through a period in recent years where stocks have been very correlated amongst themselves.

And that's an environment where it's generally harder for active managers to perform. So if correlation came down between stocks, say if we at some point arrived in a more benign macro environment, then that would help. The other thing is the dispersion between stocks, how different stocks are in terms of their valuation or their profitability.

again, if stocks are very dispersed in terms of their valuations, that then tends to help active manager performance. But all that really is just tactical. And I think they're too much bigger things that would really help to drive the performance of active managers. And not to drive the performance, but be the core focus, their business models and restore a faith in the industry. One is this idea of if we really are in a low return world and if the next five to

10 years is one where capital markets can only slightly beat inflation, then asset owners are going to have to come into active managers or managers in general and ask for return streams that can fund their liabilities. I don't think there is any such thing as passive asset allocation. So I'm almost definitionally that generation of return stream has to be an active decision. Now, of course, it can involve passive instruments as part of that, but overall it has to be active, I think. And the second thing is this idea that by the creation of so many indices and by the cheapening of broad market exposure and the cheapening of factor exposure in particular,

it finally gives a new tool for asset owners to decide which kind of return streams they should pay for. And NASA owner who has scarce dollars to spend on asset management services logically should to spend them on a manager who can give a return stream, which you cannot get from holding a combination of simple factor strategies. Hence, this idea that it's not the active share or the overall outperformance of a manager that becomes important, but it's how much idiosyncratic returns they can generate. And by that, I mean, it returns that it's idiosyncratic to a set of factors that they could buy cheaply. All right. Inigo, Frasier Jenkins of Bernstein Research. Thank you so much for that. That was great. Thank you for time.

So, Joe, I found that discussion really fascinating and much more nuanced, perhaps, than I would have thought, based on the titles of his research. Yeah, I mean, I can't. He said he wasn't at the very beginning that he wasn't act anti-passive per se. But I'm sure it's understandable why people interpreted that he was, if you're going to say it's worse than Marxism. But I get his point that from a strict capital allocation, standpoint that the essential truth of going based on the indices, which is that the indices are weighted towards size and passive investing inherently would just reward yesterday's biggest companies that that may be one of the worst ways to allocate capital imaginable. Yeah. And there are some big picture questions embedded in that idea, one of which has to be,

you know, what is the stock market actually telling us if the price signal embedded in it is being so distorted by indexes and, you know, these massive allocations of capital to the biggest companies? By the way, there are other people out there who have had a similar idea to this. You know, Matt King over at City has talked before about how markets used to be self-limiting in the sense that you'd get a bunch of money moving into one asset and eventually it would become overvalued and then money would leave that asset. But he argues that because we have so much passive investing, basically the market never self-limits anymore,

and you have inflows essentially following inflows. So, you know, this isn't necessarily a unique idea. Yeah, it's interesting to think about that. So obviously anyone who sort of maybe through a retirement plan just sort of throws money every month at a index fund that tracks the S&P 500 is, buying a lot of Amazon every month and they're buying a lot of Microsoft every month and they're buying a lot of Apple. It raises the question, would they do that if they weren't just buying

the index or would they not keep throwing money and, in fact, the lion's share of their money at the biggest company? So I really like that idea. We should get Matt. Have we tried to get mad on the show? We probably have, right? He's been on the show. Oh, you weren't there, though, Joe. Okay, the few. I was about to get really embarrassed. I missed it. Yeah. Well, let's get him back on and talk about that topic specifically. Yeah. Yeah, we totally should. And I just want to say, I talked about a little bit, but I am fascinated by this, how the relationship between stocks and bonds just keeps creeping up in our conversation. Yeah. And how many different things going on in investing could change dramatically if intra-asset class correlations were to change and how many strategies that

we think our sound inherently might end up being totally busted in a different environment, one that could come about, say, if inflation were to pick up. Yeah, it's definitely a recurring theme on this podcast. We should start an index called Risk disparity. Risk disparity. Let's do it. We have a lot of projects. Okay. All right. This has been another edition of the Odd Lots podcast.

I'm Tracy Alloway. You can follow me on Twitter at Tracy Alloway. And I'm Joe Watson. Izanthal, you can follow me on Twitter at the stalwart. And you should follow our producer on Twitter. Tofor Forges, he's at Forges T, as well as the Bloomberg head of podcast, Francesca Levy, at Francesca Today. Thanks for listening. The news doesn't stop on the weekends. Context changes constantly.

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