The Great ‘Passive’ Bubble — Part II

Burst your bubble

As we discussed in last week’s article, speculation about whether Australia’s property market is in a bubble never goes away.

But, as we also noted, it all depends on where you live. There are plenty of places outside Melbourne and Sydney that have missed out on the action. These cities and towns have missed out on the big price gains.

While the debate about the property market rages on, there’s another discussion stock market investors need to consider: the ‘passive’ bubble.

As active fund managers have underperformed the index, so too have the funds they manage scampered out the door.

Some of this is cyclical — there are times when the market simply runs away. When most stocks are rising, it’s harder for an active fund manager to beat the index.

But some of this money-flow is permanent. The days of active managers charging high fees for underperformance are slipping away. Adding insult to investors is the string of funds that charge for active management, only to closely copy the index.

Slashing management fees

Much like the stockbroking industry of a generation ago, online trading decimated the fees brokers could charge. It wasn’t unusual then to pay over $100 brokerage to buy a few grand worth of stock.

Now you won’t have to pay over $20, and there are cheaper options than that. Online trading changed forever the way the broking industry worked. The only way the industry survived was by culling ‘ordinary’ folks and concentrating on those with a million or two to invest.

A similar pressure is on the funds management industry. A growing range of products, and fees as low as 0.15%, continue to push money into passive funds.

The problem, however, is the amount of money funnelling into a finite number of stocks. As each new ETF is added, so too must they hold all the shares in the index they replicate.

Instead of buying shares on improved earnings, for example, index funds only buy them because they have to.

The more money that flows into ETFs, the more that buying pressure underpins a stock. Even if a stock’s earnings aren’t improving, the flow of funds can falsely prop up its share price.

However, if all these buyers become sellers, the opposite happens. A company performing well can still see its share price sink as index funds reduce positions.

It’s about their structure

A lot of this has to do with the way ETFs are structured. An ETF has an open-end structure, meaning that the provider can keep adding units as demand increases. As new investors buy into the ETF, the ETF provider issues additional units.

This is different to a listed investment company (LIC), which have a closed-end structure. An LIC has a fixed amount of capital from its initial listing. The only way it can add to this is by undertaking a rights issue.

If an LIC wants to add to its holdings, it has two choices. It can fund it from its existing cash. Or it has to sell down an existing holding.

An ETF doesn’t have this limitation. As more investors buy into the fund, it issues new units and buys the underlying shares.

The thing that determines the liquidity of an ETF is not the fund itself, but the underlying shares. It can keep adding new units as long as there is sufficient liquidity in the underlying shares.

It’s all about the money flow

These ETFs grow bigger as more money comes into the market. And all this money flows only into stocks inside the index.

The danger lies when all this reverses. The size of these funds — globally in the trillions — will need to reduce positions as investors exit the market. While it favours passive investors on the way up, it exacerbates the fall on the way down.

Where investors need to be particularly careful is buying into stocks whose price is trending upwards, yet earnings are going nowhere. While index-buying momentum might prop up the price, it could abandon it on the way down.

This is where it can play into an active manager’s hands. They don’t have to invest in every stock (like an index fund), and can instead hold more cash.

There are structural shifts in the way investors now place their funds. The range of low fees and better returns has seen more money flow into passive funds. It will be hard for funds that charge higher fees and continually underperform to survive.

But eventually, the wheel will turn. In a bear market, investors will exit passive funds rather than ride out losses. And, once active fund managers start beating the index again, this money flow could turn back in their favour.

Matt Hibbard,
For Markets & Money

Matt Hibbard

Matt Hibbard

While many investors chase quick fire gains, Matt takes a different view. He is focused on two very clear goals. First: How to generate reliable and consistent income in a low-interest rate world. And second, how you can invest today to build wealth over the next 10–15 years.

Matt Hibbard

Latest posts by Matt Hibbard (see all)

Leave a Reply

Be the First to Comment!

avatar
  Subscribe  
Notify of
Letters will be edited for clarity, punctuation, spelling and length. Abusive or off-topic comments will not be posted. We will not post all comments.
If you would prefer to email the editor, you can do so by sending an email to letters@marketsandmoney.com.au