The Other Great Bubble

Barely a day goes by without yet another call for the great Australian property ‘bubble’ to burst. Of course, not everyone thinks it’s a bubble. They’ll happily cite all those who have been wrong so far.

And even if the market does come to halt, it might not be the sudden burst these same pundits predict. Instead, it could be something a bit more mundane than that — something more akin to a wheezing, slowly-leaking tyre.

Whether property is actually in a bubble depends on where you live. There are plenty of people living outside of Melbourne and Sydney who have missed out on the action. What they would do for double-digit price gains year after year.

While the so-called property bubble attracts all the debate, there could be another one taking shape. And just like property, picking when it could come to an end is probably little more than a guess.

This other bubble is in the stock market, but it might be different to what you think. It’s not about lofty share prices and companies trading too far above their value.

Instead, a changing dynamic is creating this bubble. That is, the way money flows into the market.

The game is getting harder

If you worked in the marketing department of an active fund manager, you’d be doing a lot of head-scratching right now.

It’s pretty hard selling a product that, in recent times, has not only underperformed the market, but is more expensive as well.

But that’s the pressure the funds management business is under. Years of expensive fees and subpar results has seen a massive amount of funds flow out of its coffers.

For some it’s a no-brainer. Why would they park their funds with someone who’s going to charge more, only to generate less return?

Sure, some managers beat the index. The best ones do it year after year. However, the rest often struggle to match the index, and often underperform it. That’s why the money flowing out of active managers into passive funds is accelerating.

The problem, though, is that if all this money flows into passive funds, it’s going to greatly distort the market.

A self-perpetuating cycle

The passive manager’s job is to match the performance of an index. Unlike an active manager, they’re not trying to pick stocks they believe will beat the market.

Paying analysts to research stocks costs a lot of money. Much more than running an index-hugging fund, where the portfolio is set by the market.

A passive fund has to hold (as far as practicable) all the stocks inside the index. They rebalance their portfolios regularly to ensure their holdings match the index.

Each index represents a finite number of stocks. If a stock is in an index, then an index-hugging fund must own it. And the opposite holds true as well. If a stock is not included in an index, a passive manager can’t hold it.

Where the problem arises is not so much in the structure of the index itself — although this has its issues (such as overweight financial stocks) — but in the number of passive funds trying to replicate it.

Think of stocks like Apple, Intel or Johnson & Johnson in the US. These three are among the 30 stocks included in the Dow Jones Industrial Average. On top of that, they’re included in the S&P 500 index as well. Some of these mega-cap stocks can be included in dozens of other indices as well.

As more money flows into the growing number (and size) of passive funds, these funds must buy each of these stocks to replicate the index. The bigger the weighting of these stocks in the index, the more money there is going into them.

All this money coming in is invested among a finite number of stocks. The weight of new money continues to force share prices higher.

While that might be a good thing if you own those shares, eventually the market will correct itself, as that’s what markets do.

Eventually there needs to be some correlation between what a company earns and the value of its shares. If a share price continues to climb (off the back of index investing), but earnings don’t, eventually it will get found out by the market.

This is the new bubble you need to be aware of. Just as money flowed into the stock on the way up, so too will it leave on the way down. The more weight a stock has in the index, the more it will be sold off when the market takes a fall.

Matt Hibbard,
For Markets & Money

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 researches income investments. You can find more of Matt’s work over at Total Income, where he is hunting down the next generation of dividend-paying companies for the future. He is also the editor of Options Trader, where he uses basic options strategies to generate additional streams of income beyond the regular dividend payments. Having worked for himself and with global firms for almost three decades, Matt has traded nearly every asset in existence. But now he is on a very different mission — to help investors generate income irrespective of what the market is doing. It’s about getting companies to pay you a steady, stable income, with minimal stress and the least risk possible. Matt doesn’t believe you have the luxury of being a bull or a bear in the market right now. You have to earn an income from it, regardless of whether stocks are going up or down. By getting the financial markets to pay you an income, you can get to focus on more important things than just money.

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