Paying the Pied Piper of Passivity

Print Friendly, PDF & Email

The Pied Piper of Hamlin

“In the year of 1284, on the day of Saints John and Paul on June 26, by a piper, clothed in many kinds of colours, 130 children born in Hamelin were seduced, and lost at the place of execution near the koppen.”


We are all familiar with the tale of the brightly-clothed pied piper whose lovely tune was so enchanting as to lure a town’s entire population of children to their premature demise. Few may realize the legend was borne of true events. The Lower Saxony hamlet was battling a rat infestation and the pied piper originally labored to rid the scourge in exchange for payment. Rat-free, the townspeople reneged and paid dearly with their children’s lives, or so the story goes.

Listen to investing legend John Bogle and you too might be lulled. Not by music, but by a message that could have you believing that active investing should also have long ago met its own demise. The man is on top of his game with Vanguard, the firm he founded on September 24, 1974, raking in a record $236 billion last year. Total assets under management? A cool $3.1 trillion. (OK, you might should round down considering how this year has started.)

Nevertheless, Bogle makes beautifully salient points about passive investing. Active managers are too richly rewarded. Or in Bogle’s words from a Bloomberg interview last April, active mutual funds are “fat, dumb and happy,” soaking would-be retirees with excessive fees.

In many cases that assessment suits, especially when “closet indexing” is involved. Think handsomely rewarded “active” managers circa 2000 buying into the dotcom revolution’s poster children of profitless phantasmal prosperity. Or jump to present day and picture managers who veered blindly from concentrated to the core in Apple to a deep dive into the FANG stocks that we can all name.

What should be most important to investors is that index investing has proven its merit, outperforming its actively-managed peers. Morningstar tracked 562 actively managed large-cap growth stock mutual funds and 25 passively managed funds in the same asset class. In the decade through yearend 2014, passive outperformed by a significant margin, with average returns of 9.27 percent compared to managed funds’ 8.05 percent.

Bogle’s prediction: “In 25 to 30 years, they’ll be gone. That seems like an extreme statement, but I think it isn’t without possibility.”

Spend nearly a decade as an outsider inside the Federal Reserve and you realize the perilous nature of Bogle’s arguably logical conclusion. Data, one comes to understand, is akin to an artist’s canvas, clay or marble; it can be painted, molded and sculpted, conforming to the artist’s strokes. Framing timeframes is by far the most convenient method to help the data assume the shape of your intended outcome.

Don’t like the way inflation trends behave going back to the 1800s when deflation was a much more common occurrence? Slice right through history and begin in a postwar world. And voila. The results pan out just as you’d hypothesized. It bears mentioning that this line of thought has infected the collective mindset of the current generation of economists at the Fed and gone a long way towards perfecting models that justify the stifling of the business cycle.

Be mindful, in other words, that Morningstar examined ten years in which easy monetary policy ruled the financial markets’ roost. It should be no wonder that stock picking can be placed right up there beside bungee jumping with a broken cord.

In the event the little hairs on the back of your neck are standing up, that’s your subconscious asking a pertinent question: Are central bankers omnipotent? Do they have the ability to keep Mother Nature at bay indefinitely?

If you believe that to be the case, then double down in index investing. But if you’re a wee bit skeptical, consider the following less discussed index fund investing attributes care of Schroders’ Alistair Jones.

Equity index funds weight their stocks by their market capitalization. That means the go-go stocks with the most inflated prices drive the train. In a report, Jones warned “The problem is that market cap weighted indices can force investors to buy stocks with expensive valuations and sell cheap ones.” He goes on, “In other words, buy high and sell low.”

For those keeping track, the broad index is off by one percent since December 2014 but has suffered a decline of five percent if you net out the top 10. That tony top cohort is up by 17 percent over the same time frame. But the parallel with 1999 should stand as warning enough to passive investors comforted by how well their portfolios have performed. What spikes upwards will crash just as violently when the air rushes out of these bubbling stocks.

Jones’ second reservation has to do with this concept we used to be familiar with called ‘price discovery.’ Value, we learned in portfolio management 101, is what you buy at a fair price. The implication is that good companies can be bad values. “Passive managers,” Jones explains, “are not able to distinguish between good and bad, wheat or chaff. They are forced to invest in all the stocks in an index, irrespective of any views about their value or quality.”

Jones’ last concern drives at why investors have piled into passive funds care of the Fed’s enticing investors into risky assets with their own special strain to which worryingly few are impervious. Rather than disappear and never be seen by their parents again, as was the case with the town’s children and the 11th century piper, investors must reckon with the systemic risk that permeates the markets when boom turn to bust.

The bullish cabal continues to insist that if you exclude energy from your calculus, all is hunky dory in the markets. The flaw in such naïve guidance is that excluding energy extends to excluding the commodities supercycle, the emerging markets renaissance it induced and the ‘miracle’ of China’s emergence onto the global economic stage that ignited the engine to begin with.

Hence the ultimately systemic outcome of lax monetary policy and the animal spirits it emboldens when seeking out the philosopher’s stone.

Maybe a bit more business cycle and less artificiality would have left investors in a better place. One thing is for sure – there wouldn’t have been the wholesale herding into passive funds these last few years.

Market behavior suggests that an entire generation of passive investors is about to discover the downside risk of holding highly concentrated positions that have flown blind, free of price discovery. Call the highly correlated nature of their supposed prudent asset allocation a systemic-risk chaser.

Last Friday, Mario Draghi sang acapella to the roaring applause of financial markets, which rallied to close in positive territory for the first time in a month.

It’s likely that the Wall Street Journal’s Greg Ip answered the mother of all questions posed by passive investors. Their query: Why bother with the nitty gritty of identifying value in individual securities in a world in which macro is all that matters?

Ip’s answer: “Just as the Fed doesn’t determine the breadth of the boom, it can’t dictate the scale of the bust.”

The conventional wisdom is that a rising interest rate environment will lay the groundwork for active managers to finally outshine their passive brethren. A recession ensues outing the passive managers as sheep in wolves’ clothing – all good on the upside, brutal on the downside. But what if recession emerges without being triggered by a textbook tightening cycle?

The world as we know it has become dangerously interconnected. We read about the trillions of dollars of dollar-denominated emerging markets bonds that have been issued in recent years to say nothing of the explosion in supposedly safe developed-market debt and pretend that rationality has played a part.

We delude ourselves into believing that events halfway around the world can be contained. Recall the last time we bought into the notion of events being contained and consider yourself forewarned.

In the fabled fable of the Pied Piper, there was only one lucky child who was spared. The lucky child depends on the version of the story being told. In one version it was a lame child who could not keep up with the mass exodus, another version spares a deaf child, perfectly immune to the fatal melody, and still another version saves a blind child who could not make his way.

Are there modern day parallels to the survivors, ardent disciples of Graham & Dodd and idealistic short sellers standing sentry against corporate malfeasance’s entry? We can only hope.