Thursday, April 30, 2015

Implications from the Rise of Passive Investing

ThinkAdvisor shares Jeff Gundlach's (DoubleLine) thoughts from the Milken Institute Global Conference, outlining the potential impact of the shift towards passive investing within Robo Advisors.

The financial planner industry has very wide range of delivery. A lot of … asset gathers do nothing; others are very creative. With robo-advisors, the costs are low. So the draw is the lack of overall success by human advisors at three or four times the cost of an algorithm, or spreadsheet advisor. 
The impact being...
One-size-fits-all solutions channel people into the same investments, which then introduces systemic risk.
In a conversation I had with Ben Carlson (of the must read A Wealth of Common Sense), I shared that while it is odd he focused on robo-advisors given they are such a small percent of the market, his point is relevant in terms of the huge shift we've seen over the last 20+ years towards indexing. While I won't get into the details of my own view on passive vs. active investing (high level... in my view there are parallels to the prisoner's dilemma in that it is a rational choice for most individual taxable investors, but poor for investment returns / the economy as a whole), I do think it increases systematic risk due to the concentration of assets into so few products.

How much has passive taken over?

The shift to passive has been monumental; 20 years ago passive investments made up a bit more than 20% of all assets within small, mid, and large core / blend Morningstar categories, the majority of which was allocated by institutional investors with long-term investment horizons. Now, we're looking at a passive market share of 50-70% within core U.S. equities, with the bulk of net flows coming from retail investors with much shorter investment horizons.

As Ben pointed out:
performance chase by weak hands will probably always cause more volatility in any product type.
I agree and in the case of indexing, the product is the entire market. My hypothesis that systematic risk has increased due to the concentration of assets is supported by the strong historical relationship between market performance, market volatility, and passive outperformance. Money has piled into indexing (a product that is composed of the entire market) when markets have performed well, periods when active managers have underperformed and volatility has been low. Passive market shares gains have slowed when markets have underperformed, periods when active managers have had much stronger relative performance and market volatility has been amplified.

Relative performance of active vs passive (in this case the percent of managers outperforming on the y-axis and market performance on the x-axis)

This raises the question of whether the relative performance of the average active manager is due to stock selection or is instead a function of flows into the market that have been allocated irrespective of underlying fundamentals. If the latter, when flows leave the market (as they always do at some point), it won't be individual stocks that underperform, it will likely be the entire market.

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