In my last article, I mentioned Vikram Mansharamani.
A lecturer at both Harvard and Yale, Mansharamani has spent much of his life studying the booms and bust that have happened throughout history, identifying similar patterns in past booms and busts from the Tulipmania of the seventeenth century through to the 2008 banking crisis.
Mansharamani helps us to identify if a bubble might be inflating, and he examines the creation of economic bubbles from a variety of perspectives.
Mansharamani is concerned that index investing could be the next bubble to inflate.
Index or passive investing has been increasingly popular. Index investing means that you buy the whole market, good or bad, rather than asking a fund manager to buy what he considers to be good stocks.
A company is paid to produce an index that reflects a market (e.g. the FTSE All Share index is intended to reflect the U.K. stock market) and index tracking funds simply buy all of the constituents of that index in the same proportions as the index.
Index investing is usually cheaper than active investing and produces more predictable results, with returns closely matching the index chosen.
The range of results for active investors is much wider.
So, in the U.K., index tracking funds tend to follow the FTSE All Share Index; index tracking funds produce much more predictable returns than actively managed alternatives.
However, the returns from the best actively managed funds have been much better than for index trackers, but the worst actively managed funds have been much worse.
Index investing has been growing in popularity, and, last month, a milestone was reached with assets in U.S. index-based funds exceeding those in actively managed funds for the first time.
Mansharamani tells us that this is just the tip of the iceberg, with many of the other participants in the market (such as pension funds and sovereign wealth funds) also using index-tracking as their investment strategy.
The inflation of a bubble can be detected by a growing complacency around an investment theory, and this is certainly evident amongst investors now.
In a bubble, higher prices lead to higher demand (the opposite of the standard economic rule).
Inflows into index funds could well be causing the value of those indices (and their constituents) to rise; this could explain the continuing rise in the price of shares of the world’s largest companies, regardless of the companies’ performance.
In a bubble, government intervention often results in price distortion.
In the U.K., the government’s approach of reducing pension charges has encouraged index investing, and other governments around the world have encouraged index tracking by exerting pressure on fund charges.
Evidence of a bubble can also be seen when a theory spreads beyond investment professionals.
Proof of the Bitcoin bubble could be heard in the back of many a taxi-cab, and the theory of index tracking has spread way beyond professional investment managers. The outright dismissal of an active investment approach as old-fashioned, with a passive approach being increasingly touted as a sure way of making a return, is further evidence of an inflating bubble.
But there are plenty of good arguments that index-investing is not a bubble at all.
Most persuasive is that index-investing is just a way of choosing the shares you hold in your portfolio; this makes index-investing quite different to tulips or Bitcoin, where an increasing amount of money was chasing a finite supply of something.
Ironically, it seems that the growth of index-investing should, ultimately, make active investing more effective, as stock markets become less efficient. It seems likely that there will be an equilibrium position, where active managers are easily able to outperform, and this will drive investors back to active funds.
Active managers might be able to use their skill to avoid the likes of Capita and Thomas Cook, whereas index trackers will continue to buy the shares of failing companies. In a world in which fewer people are trying to capitalise on opportunities, those opportunities should become more comfortable to exploit.
Over the five years to 3rd October 2019, the best index-tracking fund in the U.K. All Companies sector has underperformed the best active fund in the same sector by 12% per year.
If index-trackers were to underperform in the future, it is easy to imagine investors switching back into active funds until the performance differential reduces.
There probably isn’t an inflating bubble in index investing, but the apparent certainty of index investors may be making it more attractive to adopt an active approach.
