As American stock markets hit all-time highs, self-directed and passive investors are frustrated, fearful and confused. Not the sentiment you may expect. But ask yourself how you feel about the market… do you think the S&P’s valuation properly reflects the state of the economy?
The Independent reported late last year that
“The U.S. Department of Housing and Urban Development Read says 565,000 people are homeless, with around a quarter of that number under the age of 18.”
For years now, an increasing amount of investors have been dumping capital into passive mutual and management funds, choosing to avoid individual stocks…
According to Morningstar, as reported by Bloomberg,
“The average proportion of equity funds in the U.S., Europe and Asia that mimic index providers’ security and country allocation decisions has doubled over the past eight years to about 33 percent.”
This trend is even more emphasized in mutual funds; documented in a report from the Institutional Investor, according to Morningstar, “assets under management in passive mutual funds have skyrocketed 320 percent globally to $6 trillion since 2007.”
No matter which side you lean towards, active or passive investing, understanding why this shift is happening, and what its ramifications could be, is critical to your strategy in the months ahead.
Passive Investors Scared into Index Investing
The mass migration into passive investments highlights an inescapable truth that, when it comes to investing in the 21st century, specifically in the post Great Recession era and in the central bank paradigm, the game is rigged. Passive investors are opting for lower fees and less control…
As the S&P 500 and Dow Jones traded to nominal record highs last week, more investors are riding the wave in passive mutual funds or index ETFs than ever before. Ironically, there are less total investors participating in the overall stock market than any time since 1995. So, despite less overall individual investors, those left are cramming into passive funds.
Where is the new money?
With stocks soaring, investors should be pouring into the markets, right? Not this time. U.S. investors are staying on the sidelines for a rather obvious reason: they don’t have the disposable income, or risk tolerance, to invest.
Consumer finance firm Bankrate.com reported last year that market participation is at the lowest level in two decades. Only about 14% of investors own individual stocks like Apple or Microsoft…
Simply put, the death of free markets (over-regulation by government and flat out manipulation by central banks) has expedited the death of the maverick investor. Those who historically have self-managed their investments are embracing the rigged system and are investing via index funds and ETFs. They’re overwhelmed with the casino that is the current stock market. Fundamentals mean less to the performance of a stock, in some cases, than monetary policy. It’s hard to blame investors for giving up…
Investors are opting for passive management for 5 key reasons:
* Lower fees
* Better Performance
* Advent of Big Data
* Rigged markets
* Less stress/perceived predictability
Let’s start with fees. Saving 50 to 200 basis points a year by investing through passively managed accounts can be huge; and it can add up to hundreds of thousands of dollars over an investing lifetime.
“Global passive equity funds and ETFs, which charge fees as low as 0.01 percent, attracted $227 billion of net inflows in the 12 months ended June 15, versus $92 billion of outflows for active funds, which have an asset-weighted management fee of 0.62 percent, according to data compiled by Bloomberg…”
Performance: The passive management style (index investing, for the purpose of this discussion) outperforms actively managed accounts by a large margin. In fact, “…up to 86 percent of active funds underperform their benchmark…” according to a recent report from the Institutional Investor. The superior performance of index investing, especially after factoring in costly fees and commissions associated with actively managed funds, is well documented. While a select handful of active money managers make headlines every year, the vast majority lose to index funds over the long-term.
Big data investing — or ‘algo investing‘ — is not a trend, but a rising tide that is here to stay. From big data analytics companies such as CapitalCube.com, which uses data to create predictive analysis on tens of thousands of equities every day and in real-time, to a firm such as Betterment that now has over 150,000 customers with more than $4 billion invested, the growth has been staggering.
Betterment reports that,
“Our portfolio is maximally diversified, and comprises low-cost, liquid, index-tracking, exchange-traded funds, or ETFs. We use tax-efficient algorithms and automate optimal behavior to maximize your ability to grow your money.”
Yes, you read that correctly, “automate optimal behavior”. Computers are creeping deeper into our investment lives and in the cashless society; to some extent, all investors will defer to computers and ‘digital wealth’. Do you really think your money manager, a mere human, can compete with a super computer?
As for the rigged markets, you don’t have to look far. Whether its Michael Lewis, author of the book, “Flash Boys: A Wall Street Revolt,” who claims the U.S. stock market is rigged in favor of high-speed electronic trading firms, or any other weekly story on the topic, manipulation is clearly taking place. Just look at the recent Libor Scandal, in which Barclays Bank, JP Morgan, Swiss bank UBS, Royal Bank of Scotland and Deutsche Bank were all fined by financial regulators. Veering away from a ‘free market’ has lost people’s trust in the system.
Investors and money managers know the big banks and central banks are in control, so they might as well save the fees and anxiety by just going along for the ride. This will put even more pressure on the Fed and U.S. government to inflate the stock market as millions of Americans pile into passive mutual funds…
Fed Rigs Market by Window Dressing the Economy
Another element fueling the Fed is the public’s perception of the U.S. economy and the consumer confidence realm. Passive investors and index investors are almost always long various indices. A perceived strong economy makes this type of investment seem logical and comforting…
Annual U.S. GDP growth has been trending lower for decades. It increased by just 1.1% in the first three months of 2016. Factory Orders declined for the 19th month in a row in May. According to Zero Hedge,
“Simply put, in 60 years of historical data, the US economy has never, ever suffered a 19 month stretch of consecutive annual declines…”
Sections of the U.S. economy, including the manufacturing sector (monthly trade deficits in the U.S. continue to average $40-$50 billion), have been crushed in recent decades. So, why is consumer confidence rising, along with the stock market, to near all-time highs? Can the two still be related when only 14% of Americans own an individual stock?
The Index of Consumer Expectations focuses on three areas: how consumers view prospects for their own financial situation, how they view prospects for the general economy over the near-term, and their view of prospects for the economy over the long-term.
What do Insiders Know?
While the Fed may have the mainstream economy and investors excited, insiders are not as convinced. Late last year insider sales hit near record levels.
Insiders of U.S. companies provide an unfiltered look at the real confidence behind their respective sectors. The data is not comforting, and it supports the theory that U.S. stocks are overvalued.
Systemic Risk to U.S. Markets and Passive Investors
Whichever asset the Fed decides to prop up next, passive investors are hoping it will fit the criteria outlined to make it into their index of choice. The Fed knows this and is aware that the Dow hitting new all-time highs makes headlines and attracts further passive investment. This keeps the game going. However, what this rush into passive investing also does is increase systemic risk if the Fed loses control.
Some prominent money managers are worried about so-called ‘market distortions’ related to index-tracking investments. Bloomberg reported:
“…with money moving into or out of shares because of their status in key indexes, instead of anything to do with the securities’ underlying value, according to Equitile Investments’ Cooper.”
With the exodus of active investors, who will be left to move small and mid-size companies? Who will partake in price discovery? Will it be the Fed? Big banks?
As control and manipulation increases, real economic opportunity decreases.
All the best with your investments,
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