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Bubble economics: the active vs passive debate

Posted By Drew Dickson On September 12, 2019 @ 4:03 pm

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Michael Burry’s comparison between passive investment in equity markets and the bubble in the synthetic CDO market back in 2007 (which he famously – thanks to Michael Lewis and Christian Bale – identified) sparked a robust debate this month.

Financial specialists on Twitter, a broadly pro-passive audience to begin with, mostly disagreed. This is for good reason, as passive investing is a lower cost way for retail investors (at least) to gain exposure to rising equity markets over the long term.

But I thought the chastising of Burry was a bit overdone. Burry asked a thought-provoking question, it’s just that “bubble” was the wrong word to use. It was wrong, because there is no bubble in passive investing, but the word was so incendiary that it was difficult to stay objective.

But it’s okay to ask if passive flows are affecting share prices. People have been asking these questions for decades, and the volume of analysis here is only increasing. These are interesting, even confusing, times. Money is pouring into passive vehicles, value hasn’t worked for over a decade and the S&P 500 is up 400% since March 2009.

Burry is simply wondering if the trend toward passive investing is having any impact on the prices of companies that are or are not in these indices. This is a good question – one I have been thinking about since my dissertation on the subject in graduate school, many moons ago.

Even back in 1998, it was reasonable to ask whether, given passive investing was becoming a larger part of the market, its effects were increasing with time. My co-author Craig Dawson and I didn’t reach that conclusion but left open the idea that with more time, datapoints and flows into passive funds, we might.

Now, 21 years later, the overriding question we are all asking is if passive investing is at the point where there are not enough active investors to correct prices. In other words, are we at the point where the passive free-riders are actually making prices?

At least at the broad, market level, I don’t think we are. Indeed, Cliff Asness – specifically on the issue of index investing and the “free-rider” issue – points out that accurate prices in many goods happen without so much impact from the “wisdom of crowds” but instead by expert judgment by just a few people.

But I simultaneously disagree with the view that pricing is always unaffected in the intermediate and long-term by behavioural biases. There are a host of strange behaviours that affect certain subsets of the market (value stocks, quality stocks, momentum stocks, etc).

We do not think that the tail is yet wagging the dog. We do not believe that passive investing is a bubble, nor do we believe that it is to blame for the underperformance of small caps or value, nor even that they deserve credit for strong equity markets in the US.

This is where it gets even more interesting. Ben Hunt of Epsilon Theory found the reaction to Burry’s article revealing. He saw it as rooted in a constantly-reinforced view that everyone knows stocks as an asset class always go up, and that passive vehicles are the cheapest way to get there. And the second-order, Keynesian-esque argument is that everyone knows that everyone knows these things.

He thinks this results in (and creates) the narrative in which we all are really saying “be long”. And given the S&P 500’s decade-long and continuing rise, that mantra is no surprise. Ben highlighted historical periods when the accepted faith – the things that people believed that people believed – was that markets did not go up forever. People operating under that faith actually did very well until things changed. And they did change.

And maybe they will change again? Will the undying love for passive investing will become a little tainted if the markets ever decide not to go up? What if some of this anti-Burry, pro-passive sentiment is a sign of the times, rather than something that we can be certain will always be?

This isn’t an unreasonable perspective, and neither is the view that “passive” investing is not in a bubble. As such, despite the fiery rhetoric from all sides, I don’t think my smart friends on Twitter are in as much disagreement as it appears.

Dickson is founder and portfolio manager of Albert Bridge Capital in London. This is a condensed version of the full article, which can be read here [1].