Kopin Tan in Barron’s had some fascinating numbers about the flows into passive funds;
Over the past two years alone, investors have pulled $574 billion from actively managed U.S. funds and plowed $924 billion into passive vehicles, says Morningstar. Active U.S. managers oversee $9.7 trillion, but that haul hasn’t grown much in four years and is just seven times the 1993 total. In contrast, the $5.4 trillion in passive funds has doubled since 2012 and has grown 158 times since 1993.
A large dynamic in this flow is chasing heat (performance chasing). Additionally, the numbers don’t capture the extent to which passive funds are being used in active strategies whether that is professional investors going in and out of the largest indexed ETFs, advisors using an index ETF to equitize a new client portfolio for a few months while building the actual portfolio for that new client or even do-it-yourselfers, day trading MACD.
A common criticism of indexing is the extent to which the index tilts more and more toward growth as the bull market matures because the growthier, high fliers go on a run of outperformance later in the cycle (this is historically how it has worked). Those are the same types of names that stand to go down a lot, really a lot, during bear markets. It is a good bet that most of these types of stocks will bounce back to new highs in the subsequent bull market but it is at points of maximum pain the poor decisions are made.
If you knew that 20 years from now the S&P 500 (NYSEARCA:SPY) would be up 200%, there would be no reason to sell out of fear yet people would (the example makes assumptions about asset allocation and time horizon but bear with me). Why do I pick 200%? Because over the last 20 years the S&P 500 is up 207% (per Google Finance). Twenty years from now the market will be much higher, maybe less than 207% or more but despite knowing this people will panic sell the next bear market/crisis because it will be “different.”
Look at the current top ten of the S&P 500. Five of the top ten are the types of tech stocks (or tech related in one case) that are likely to go down a lot in the next bear market (not a prediction, more of seen that move before situation). There is also one industrial stock and stocks in that sector are no stranger to cutting in during bear markets and recessions. Even though logic tells us that after the next bear market there will be a new high with the only variable being how long, there will be puhlenty of people that succumb to their own fear and sell at a point of maximum pain.
Indexing can absolutely work but it exposes investors to a higher risk of having to face maximum pain. A comment I’ve made many times before is that finding out you had too much of something after it just cut in half is a bad place to be. Another one from me; being disciplined 75% of the time won’t work and really, I should have said being disciplined 90% of the time won’t work.