Has the demand for tracker funds gone too far? Certainly, history warns us that investment fashions can end nastily. Think of small caps booming in the 1980s only to suffer a decade of underperformance in the 1990s, or the tech boom and bust, or the mania for credit derivatives in the 2000s that led to the banking crisis.
And there is a reason to suspect that there might come a time when tracker funds should underperform active ones.
Andrew Lo at MIT has proposed a nice analogy to explain why. Investment strategies, he says, work like population cycles in biology. If a species becomes abundant, it depletes its food source, which causes the species to decline. That eventually allows the food source to grow back, which allows species numbers to recover.
For a long time, active managers have been like a super-abundant species. So many of them have been looking for mispricings that they have eliminated many of them. Active managers have thus done relatively badly. That’s caused them to shrink – in terms of numbers and funds under management – and passive funds to grow. If this trend continues, however, fewer fund managers will be tying to look for mispricings and so the market will become more inefficient. The food source (mispricings) will become more abundant and so the species feeding on it (active managers) should grow back at the expense of passive managers.
There is, therefore, hope for active fund managers to recover.
Or is there? There are good reasons to doubt this story.
For one thing, even if there are lots of mispricings it does not follow that we can actually spot them at the right time. A big reason why active managers have failed is not so much that the market is efficient as that it’s just so difficult to identify underpriced stocks. The Nobel laureate Friedrich Hayek pointed out that nobody can be sure of having so much information that they can do a better job than the market. He was talking about central planners, but the same point applies to stock-pickers. And another Nobel laureate, Daniel Kahneman, inspired research showing that we all make countless errors of judgment. Yes, such errors suggest that shares might be mispriced. But they also suggest that we are incapable of spotting them.
But even if there were a wise and fully informed stock picker, he would face huge problems in making money.
One way in which trackers allegedly distort the market is that they must buy stocks that have risen in price simply because these account for a greater share of the All-Share index, thus causing them to become over-priced. To profit from this, an active manager must short-sell the stock. This means he must bet against momentum. But we know that past winners tend to keep rising, so this is dangerous. And this is not to mention all the usual dangers that accompany short-selling – such as the fact that even if you are correct eventually you’ll need to put up more cash as collateral against your position if the price rises in the short-term. To profit from short-selling, it is not enough to be right. You have to be right at the right time. And that’s tough.
Worse still, it’s not just tracker funds that active managers will trade against in this scenario. Because momentum works, some active managers will seek to profit from it, and so buy as tracker funds buy.
But what about stocks that fall in price as tracker funds sell them because they have fallen as a share of the index? Can’t active managers scoop these up?
Not easily. Buying a falling share also means betting against momentum and disobeying the old maxim: “never try to catch a falling knife.” That too is dangerous.
For these reasons, even if the market is inefficient, it will still be very difficult to profit from this fact.
All this, however, is only theory. Passive management is still small. The Investment Association says that retail investors’ buying of passive funds overtook sales of active funds in 2018. But because new flows into funds are only a small fraction of total assets under management, only 16 per cent of retail investors’ money is in passive funds. Trackers, then, are still some way from dominating the market.
But let’s suppose that all this is wrong, and that passive funds dominate the market and that active managers do have mispricings they can exploit. Even then, we’ll not be able to tell for sure that they are in fact superior to trackers.
Last year, more than two-thirds of funds in Trustnet’s database of all companies funds beat tracker funds. But this might well have been dumb luck. Most stocks beat the market last year, thanks to falls in the largest ones. That meant that an active manager with average luck would have outperformed trackers even if he’d simply picked shares at random. To be even moderately confident that active managers really are superior, we’d need to see years of consistent outperformance under different market conditions – bull markets and bear markets, and small caps outperforming large ones and vice versa.
It’ll be a long time before we have such data. Which means the debate about the merits of active versus passive management will run and run.
