As I mentioned yesterday in part 3, passive investing is a rule-based system and a fairly simple one. Put your money into an index, and buy all of the components at the current weight. This is the case regardless of whether you purchase a mutual fund, ETF, or some other vehicle. You simply buy the index, taking its weights as gospel.
If markets are efficient, this kind of rule-based approach makes a lot of sense. In fact, it has done very well, which is why it has grown to such a large part of the investment universe. Like any other dominant rule-based approach, passive investing will continue to work until the rules change. The question we have to ask is, “How can the rules change?”
Check the underlying assumptions
The best way to see which rules are most vulnerable is to consider the underlying assumptions on which the rules are based. In passive investing, the rules assume that the index is a good representation of the investment universe and that the relative weightings represent what securities are really worth. If both of these rules hold? A passive rule-based strategy will continue to work.
Of the two assumptions, indices (by construction) hold the relevant securities, so that one is likely to continue to hold. This leaves us with the base assumption that security valuations within the index are what they are actually worth. Here is where the problem is likely to arise.
For a market to be efficient, buyers and sellers are presumed to be buying each asset based on their independent assessments of value. As such, if a price gets too high, sellers will drive it down, and so forth. In an efficient market, securities are priced at reasonably close to fair levels.
In a rule-based system, which does not focus on individual securities, that assumption starts to relax. When most buyers are still trading on individual securities, pricing holds. But the larger the proportion of buyers who are not looking at individual security prices, the more prices can get disconnected from fundamental values. Passive rule-based strategies hold as long as the basic rule—that securities are fairly valued—holds. When that rule breaks, as excessive investment regardless of price would do, so will the strategy. This is the rule change we need to watch for.
Where are we now?
In U.S. markets, given the rise in passive investing as a style, you can make a good argument over whether we are now at the point of excessive investment. I know that we are closer than we were five years ago. And, in fact, I suspect we already are there. Which means now is the time to start watching for that rule to break.
You can look back at history and see previous episodes (as we discussed yesterday) where rules overrode pricing. The Nifty Fifty, the dot-com boom, the housing boom: in every case, the overriding logic, the rules, said that pricing didn’t matter. Using the Waze analogy, investors drove through the warning signs without thinking, guided by a model that, presumably, knew more than they did.
Right now, almost regardless of how you look at it, the market is at or close to the most expensive levels of all time. You can find ways to justify this, and many do. Still, the fact remains: any argument that says prices are in fact well founded, and reasonable, essentially devolves to the idea that things are different this time. This is an argument we have heard before, in similar situations.
Really, the only way prices can disconnect from gravity for an extended period is to find some way to argue that they don’t matter. A rule-based system, of any sort, has a track record of being good at just that. Again, just as you would have expected rule-based systems to outperform in the current environment—and they have—you would also expect arguments to proliferate over why that outperformance will continue indefinitely. It may well continue, but not indefinitely.
The road ahead
Understanding the situation only gets us so far. The question, of course, is what can we do about it? How do we drive the road, even as conditions deteriorate, without giving up on the very real benefits of the map? We will conclude with that discussion tomorrow.