I came across an interesting factoid the other day:
'Not a single mutual fund — not one — managed to beat its benchmark regularly and convincingly over the last five years. These results are even worse than those of 2014 and 2015, when I last examined this subject closely.' https://t.co/X2Ytbku1B6
— Jesse Felder (@jessefelder) December 2, 2022
Fans of passive investing clearly take this as validation of their preference for simply allocating their capital as the index dictates. However, I think that may be too convenient of an inference to derive from this. In fact, it may be looking at things backwards.
If you take a moment to think about the factors that might be behind this statistic, it starts to become far more interesting. Flows to passive funds over the past five years have been massive and accelerating while just about five years ago active funds began to lose assets, a phenomenon which has also accelerated in the years since.
— Jesse Felder (@jessefelder) December 6, 2022
Is it possible, likely even, that this dramatic outperformance of the index over active funds was driven largely by flows rather than the lack of skill of active managers or some other explanation? In other words, could it be that the popularity of passive investing explains its success more than its success explains its popularity?
Furthermore, if it is true that the performance of the index has largely been driven by flows over the past five years, rather than the collective opinion of educated active investors, then how efficient is the market truly? Is it possible that the popularity of passive investing has helped to inflate another stock market bubble?
'The stock market losses that we've observed year-to-date are merely a give-back of the frothiest segment of the recent market bubble. Our most reliable valuation measures still match the extremes we observed in 1929, 2000 and the 2020 pre-pandemic high.' https://t.co/oGPiHws6xC pic.twitter.com/KoV4FHE9HC
— Jesse Felder (@jessefelder) November 21, 2022
Remember, passive investing is founded upon the idea that the markets are efficient and thus investors mirroring the index will realize the collective returns generated by the underlying businesses. But should the market become divorced from its underlying fundamentals due to the dominance of price-insensitive buying, what then should passive investors expect?