Are index funds the next bubble? The hidden risk of passive investing

0:00 The figures speak for themselves. The passive funds have not uh beaten active funds by a little bit by, you know, by the extent to which they are cheaper than the active funds. They've they've done twice as well over the last 5 years. Hello everyone and welcome back to the personal investor podcast. I'm Ed Monk and I'm joined today by Fidelity investment director Tom Stevenson to talk about the ongoing dominance of passive investing and why some of the country's most renowned investors are warning it could have dire consequences for stock markets in the future. The most extreme predictions include the emergency closure of markets, possible government bailouts, and volatility that makes previous crashes look like walks in the park. So, what's going on and do you really need to worry about it?

0:46 Before that, let me remind you that if you find this video useful or interesting to please subscribe to the channel, give us a like, leave a comment if you want to do that, and once you've subscribed, remember to hit that bell icon at the top of the page to turn on notifications to make sure that you get new content as soon as it is released. Uh, that all said, Tom, welcome back to the pod. How are you? >> I'm very well, thanks. >> Okay, now as mentioned there, Tom, this is all about passive investing. uh for anyone that doesn't know I'm sure lots of our viewers do know but what is passive investing and and what is the recent track record of passive investing investing been >> okay so passive investing is uh as the name suggests the opposite of active investing active investing is going out uh looking at the fundamentals of a company picking stocks on the basis of those fundamentals are they cheap are

1:32 they growing fast do they have strong balance sheets etc investing doesn't bother with all of that it's simply attempts to mimic or track uh a stock market index by buying all of the companies within that index. Usually, but not always, uh in proportion to their size within that index. And for normal people, normal investors, they will buy a fund that does that, that tracks the market. Uh and increasingly an ETF, an exchangeraded fund that does it. And that way of investing has now become the kind of majority way of investing. >> Yes. Uh there is more money invested in uh passive funds today than invested in in active funds. That's happened relatively recently and that is a

2:18 complete transformation of the situation. You go back 10 20 30 years ago and passive funds were were really the the minority. Now you asked about the performance of um passive funds. uh in recent years passive funds have performed extremely strongly and I'm sure you know we'll probably get into some of the reasons why that might be the case um but it becomes slightly self-fulfilling because uh the performance has been very strong more money comes into those passive funds and they start to perform even better becomes a very difficult environment for active managers to compete with those uh passive funds in that situation. >> Yeah, absolutely. Um it does make life pretty uncomfortable if it's your job to invest actively. Uh, which brings us to a very famous active investor in famous in the UK at least, Terry Smith. Uh, I

3:05 think lots of our regular audience are going to know who Terry Smith is, but uh, introduce him anyway for us, Tom. Uh, and tell us why, uh, or what he's had to say about all of this recently. >> Yeah. So, uh, many people will be familiar with Terry Smith, uh, as a fund manager. I mean, I go back long enough to remember Terry Smith when he, uh, was an analyst. He was one of the best known um banking analysts uh actually in the city. Uh we're going back to the 1980s now. But in 1992 uh he was working for UBS Phillips and Drew as it was then um and he was the head of research there. He wrote a very uh well-known and controversial book called Accounting for Growth which was uh essentially about the tricks which companies employ to

3:51 make their profits look better. >> Right? UBS was not very happy with uh with with this. They told him not to publish the book. He said, "No, I'm going to publish it anyway." So, they parted company. And actually, it was probably the best thing that could have happened to Terry Smith because uh you know, after various other things that he did along the way, he then set up his fund management company in 2010, I think, um and launched uh his flagship investment fund, which is called the Fund Smith Equity Fund, uh which is how most people would know him. and his reputation as an investor is a as a as a growth quality growth investor. Uh in a nutshell, what's the philosophy? >> Yeah. So, so essentially uh Terry Smith

4:38 looks for companies which can continue to deliver steady strong earnings growth through the cycle. Um and uh it's it's the style is called quality investing. It's what is what it sounds like. He looks for high quality companies, strong balance sheets, uh strong growth prospects and um you know trading at a reasonable price. So he's very much an active manager in this debate that we're discussing here. His approach is very much active uh management and it and it and it um leans on his background. That's why I mentioned that background as as an analyst because it really uh you know that's fundamental to his investment style. He's he's looking for companies that can deliver the growth for good reason because they're high quality companies.

5:23 >> And you framed the performance of active versus passive. Uh he's suffered in this uh sort of uh this period. Uh in fact, he suffered so much that he's been talking to his own sort of fund investors about about this. What did he have to say? >> Yeah. So for many years of course uh Terry Smith did extremely well. Now you know that you know you you might question whether he was in the right place at the right time or whether he was genuinely a good investor and probably a bit of both. Um but recently he has fallen fallen foul of this um trend this dominance of passive investing and how difficult it's been for uh active managers to keep up with uh wi with the passive funds. He wrote a letter a couple of weeks ago uh a

6:09 halfearly uh report to the investors in his fund essentially explaining why he had underperformed and in that period um uh the uh the value of his fund had fallen by 2.9% I think it was and that compared with an 11% rise in the MSEA MSCI world index. So in investment terms, that's a pretty significant underperformance. And he was seeking to explain why he'd done badly. And he did it by addressing this this uh question of passive investing. >> Yeah. So he's done much worse uh versus those those passive funds. Um and the letter is fascinating, isn't it? I think it really makes good reading. >> Um it's it sort of amounts to a a whole

6:56 sort of thesis of what is going on. comes up with some quite scary um sort of conclusions or prophecy is probably a bit strong but but sort of it's almost like he thinks that the whole world's gone a bit mad >> and he puts that case in this letter. >> Um we're going to discuss some of this some of the things that he says. We should say at this point I think >> uh Tom that um what we're going to sketch out are some quite extreme scenarios. We're not saying that Terry Smith is betting on that happening or believes it's going to happen. Um, this is all very hypothetical. It's no one's base case necessarily, but it's very interesting to to to sort of talk over

7:42 some of these ideas. And we should say, of course, that we are not advocating a particular approach here, are we? We're not saying that active is better than passive. Fidelity offers both passive and active solutions. I'll declare my interest, Tom. I invest both passive and actively. Um so we're not sort of taking a side here. >> No, we're not taking a side. It's it's an interesting debate. Um uh it's a very interesting debate actually about you know the the the future direction of markets and how the changing structure of markets in terms of this balance between passive uh and active. You know as I said more money is now invested in passive funds and active funds. how that is changing u the outlook uh for markets and potentially what might happen if markets switch from being generally

8:28 positive and rising to to to falling and that I think is one of the there are lots of strands to his argument but one of the one of the strands is well what happens when the market goes the other way >> yeah exactly and and what I thought was so interesting uh he acknowledges that he's going to have to adapt his approach uh he mentions the underperformance comes to the fund. He also mentions the outflows which as a as a fund manager of an open-ended fund. Um that is a problem and it's presented him with a problem. Um so it's not like he's completely throwing out his philosophy completely but he is course correcting we can say uh he's still going to be focusing on quality. Um so good fundamentals. He has numbers to show that. that he's going to be paying more attention to momentum and

9:15 momentum is a a big part of why passive investing has worked. He's less likely, he says, to just simply buy what he thinks are good companies at cheap prices. He's going to pay attention to whether or not the rest of the market is going to do that as well. >> Um he's even going to be rebying some stocks that he had previously sold. So, a real a real sort of acknowledgement that that things need to change. But it was the tone around all of that, wasn't it? It really sort of amounted to Terry Smith sort of really lamenting the way the wider investment world has gone. >> Yes. And to his credit, he doesn't sort of, you know, he doesn't sort of moan about it. He just he just he just recognizes that this is the reality of how markets are working. and uh he's

10:03 accepted that he needs to adapt his style in order to be uh successful or to be successful again as as as he was um before because you know traditionally an active manager um has been able to adopt a sort of slightly arrogant position if you like of saying look you know you know I know better I you know I've done the work I've done the number crunching on these companies I know that these are good companies they they they're too cheap I'm going to buy them but what he's acknowledging ing is that in a world that's driven by momentum, uh, which is largely a product of of the the move to to passive investing, it does almost it doesn't matter that you're right. There's no point in being right if the weight of money is pushing against you and you're swimming against

10:49 the tide and you're just, you know, unable to to beat the the the trend in the market. >> Yeah. Um, we're going to go through some of the points that he makes. Um, one one of the things he talks about a lot is is a sort of um a feedback loop that can happen with with passive investing. I'm going to mention here another article written by someone else, someone called Simon Evan Cook. He's a fund of fund manager. He's been around for a long time, very experienced. Uh, he's actually name checked by Terry Smith in Terry Smith's letter, but this is also a very good article. I'm going to link to both of these in our in our show notes. um they both talk about this feedback loop that could happen with passive investing. What do they mean by that? >> Yeah. So, so what what they're talking about is is the way in which uh uh um

11:36 the the performance of funds can be almost self-fulfilling that you know as as money goes into a passive fund just by the the very nature of how a passive fan fund works more money will go into the biggest uh and you know it's often the most expensive companies within an index and as the money goes in they become even bigger and even more expensive uh and and the fund performs well and outperforms and then more money goes in and it you get this loop where it uh it just you know feeds on itself uh and and and and the same works in reverse for the active fund. It can be very difficult when you know you are you're you're as I said before swimming against this tide. you're set you're you're putting your money into the most

12:23 attractive the cheaper uh the smaller companies often um but you're just blown away by the by the unstoppable force of the passive money. >> Yeah. And they both make this point about about the the great outperformance of act sorry of passive funds um saying that that was not the original promise of passive index funds. Now, if you invest in passive funds, you're not complaining about this, by the way, but they the the original thesis behind passive funds was that, okay, you're going to get uh you're going to capture the average return of the market and there'll be active funds out there doing better than you, and there'll be active funds doing worse. You're going to get something in the middle, but you'll be paying lower charges. So, that means that on average over long periods, you're going to get uh an advantageous return.

13:09 >> Um that is not how passive funds have behaved. They've been amongst the very best performers anywhere. It's been a real struggle for any active funds to do to do better. I dare say some have, but very very rare for that to be the case. >> And it's almost as if >> passive funds >> are are in a way more concentrated. They are more active in that way than the active funds. And it's the active funds that have now assumed a position of being >> uh more sensibly spreading your money. Yeah, I mean there's lots to unpack there. I mean the you're right that the figures speak for themselves. The passive funds have not uh beaten active funds by a little bit by you know by the extent to which they are cheaper than

13:55 the active funds. They've they've done twice as well over the last 5 years as as the as the active funds. So uh you know you have to ask yourself why and one of the reasons why is as you say because they they are effectively acting as passive as active funds. They are taking big bets on individual sectors or companies you know some you know maybe half the value of an active fund is represented by only a handful of stocks maybe 10 10 stocks. So you're you're you're maybe unknowingly making a big bet on a particular corner um of the market. Uh so uh you know that that's that that that's that's one of one of the issues here. Um but it's as you say it's not what passive funds were set up

14:42 to do when they were originally set up. It was because the the the the creators of passive funds said look these active managers are charging too much money. They're essentially ripping people off was the accusation. So, we're going to do it differently. We're going to do it in a more democratic way. We're going to do it cheaply. And of course, passive funds are cheap because it's a mechanistic process. A computer can do it for you. You don't need expensive analysts to do it. So, that was the promise. We're going to give you the average return and we're going to charge you less. >> And in those sort of early early days of passive, they were very much on the coattails of of the majority of active investors out there doing it. That balance has completely shifted. you know, the the most people are on the coattails and there's very many people wearing the coats. >> And that is and that's the really important point that you know, you

15:28 require a vibrant um active sector in order for the passive sector to work because you need the active analysts, fund managers setting the price, setting the correct price for the passive funds to follow. If there aren't if the balance shifts and it doesn't have to be 100%. If you've got 90% of the market in passive and only 10% in in inactive, then the active managers no longer have the power to really set the price and then the system doesn't work anymore. >> Yeah. And one of the counterarguments to all of this, and I've spoken to people who said, well, actually, you really you don't need half of investors to be doing it actively in order for there to be an active um influence in the market. It can be much smaller than that. >> Fine. But a point and I think Simon Evan

16:14 Cookook makes this point is that it could create inefficiencies and that should be great for the active manager looking for fundamentals looking for where the market's got it wrong but they might spot those opportunities but you have such weight of money from passive that they're going to get they're going to get swamped and that when the tide turns if it turns >> it won't be enough to simply say ah well you know I'm I'm buying these uh these other betterv valued companies is the exodus will be such that you'll just be sort of pulled out with it. That is another key point that you know uh if the if and when as and when the market turns because inevitably it will at some point if there isn't uh a buyer on the

17:00 other side of the trade from the from the passive funds selling um mechanistically if there isn't an active manager looking at the values and saying whoa that's that's really cheap now I'm going to buy it or if they're so small that they can't make any difference then there's going to be nothing to stop that downward ward movement in in the market and I think you know the fear is that you then get this sort of gap lower you know it's not just a sort of steady fall it's a boom um and you get you get repeats of the sort of you know like you know like the 1987 stock market crash where where markets you know fall a lot in a very short space of time and that is obviously very bad news for investors bad news for for sentiment and you know some of the things that Simon Evan Cook um talks about is well what might happen in that situation you know will

17:45 governments step in um will they start buying um ETFs to hold shore the market up? You know, is that really sort of you know a sort of you know a betrayal of the sort of the capitalistic impulse you know I mean he talks about lots of sort of >> you know quite extreme scenario end of the world stuff and that's obviously not the sort of central case for most people but but they're things worth considering. Yes, I I mean, yeah, he talks about, you know, circuit breakers for markets and actually that volatility point and Terry Smith has some real um humdingers of sort of recent examples of companies, big big companies, particularly in the US, particularly sort of tech exposed companies, but um experiencing huge legs up in their in their values. You know,

18:31 companies that are already worth billions and billions suddenly worth 20% 30% more overnight. Yeah, >> that kind of volatility is new and he sort of he warns you know that if you take something like the financial crisis where you saw 50 60% fall over many many months >> you might see those falls in days. >> Yeah. And that would be extremely shocking uh for people who had you know set their savings up for you know for a purpose like retirement and that kind of movement would be would be really alarming. >> Yeah. and and and and and finally on these on these sort of um these missives that have been put out uh Terry Smith almost at the sort of closing sort of arguments of his of his letter and a

19:16 sort of feels like his sort of proof or conclusive proof that the world has gone completely bad he has a a chart doesn't he and the chart is of uh the performance of of different American companies over the past sort of year year and a bit >> and there's a line which shows the performance of companies with positive earnings earnings per share. >> In other words, >> they're making money. >> Uh and the performance of companies with negative earnings per share, the ones that are losing money. Yeah. >> And what does that show us? >> And and and guess which one has outperformed over the last 18 months. It's the lossmaking companies. So that is that is saying that the market is not, you know, looking at this in an analytical way, the kind of way that Terry Smith, you know, grew up doing. um uh it is doing it for some other reasons and that is probably to do with momentum

20:03 uh and sentiment and nothing to do with real valuations. >> Yes. And and and it leaves us with a question Tom what on earth an ordinary investor I speak for myself here as well is supposed to make of all of that because it can feel persuasive. We can all agree that it looks crazy um but the world can be crazy for quite a long time. Um and things don't have to unwind in the most explosive way always. No. >> Uh what to do because it it feels like a huge call to sort of bet against passive which is essentially the same as saying I'm going to bet against the largest companies in the world. Really? >> Yes. And and and if you had done that over the last few years, you know, you would have paid a heavy price because as we've discussed, they they have outperformed significantly. I mean, I

20:48 think the only way that you can really protect yourself against these sort of unknowable uh eventualities is to is to is to spread your investments around in different ways. So I you know I mean you said yourself that you invest both passively and actively and I think that's a very sensible approach because you know you do want to have exposure to the ongoing performance of the passive funds and the ongoing rise of the market but equally you know there there is a a future which is foreseeable where active actually comes back into its own and and and these the managers looking for these cheap uh stocks actually have their moment in the sun. you know, a bit of balance between the two. >> And if it does happen, it'll happen quickly. You want to get ahead of it. >> Yeah, exactly right. >> Okay, Tom, that is as much time as we

21:35 have for now. I I will just remind you all that if you found this useful or interesting to please subscribe to the channel, hit that bell icon to get notified as soon as new content is released. Give us a like and share the episodes. It really does help other people find what we're doing here. That all said, Tom, thanks for joining me. >> Thanks, Ed.