Happy Anniversary, Mr. Market
Later this week we will celebrate the tenth anniversary of the current Bull Market in US stocks. This historic run has taken the S&P 500 from a numbing low point of 666 to last night’s close at 2789. That is some run! What has changed in the last ten years? What lessons have we learned from this move? What do we need to acknowledge in order to be better investors in the next ten years? Is “Mr. Market” different this time?
The single biggest shift in the market in the past ten years is the move from active to passive investing. Translation: investors have chosen to use index funds and ETF’s as opposed to actively managed funds during this great bull run. The passive investing momentum has been building up for many years, as indexing started back in the 1970’s. The speed into indexed products has increased intensity, however. Vanguard Funds, the leader in the field, saw assets increase 20-fold between 1999 and 2018.
The Federal Reserve Bank of Boston’s Research and Policy Unit published a paper last summer that illumines us on the indexing phenomenon. One fact from this report: As of December, 2017 passive funds accounted for 37% of combined mutual fund and ETF assets in the United States. The figure was 14% in 2005. Endowments, foundations, and even public pension plans (including a portion of Pennsylvania’s retirement plan) have joined the indexing bandwagon. The biggest concerns expressed in the Federal Reserve report centered on liquidity, volatility, asset-management concentration, and changes in co-movement among investments. So what do we need to worry about?
First, according to the study index fund investors are less sensitive to investment performance than active funds. This makes perfect sense. People have abandoned the hope of outperforming “Mr. Market” and are investing for the long haul. This benefits financial stability. Evidence suggests liquidity concerns are reduced, although prices of individual companies may be less accurate.
Less sensitivity to performance creates opportunity for the active investor, as index strategies are momentum based – they buy when prices go up and sell when prices go down. Active investors know and understand this rebalancing effect, and may be able to capitalize on it. It is one reason trading in the last thirty minutes of the day is often hectic. And active investors who can separate the better companies from the more mediocre ones within an industry should find more opportunity. Bottom line: Volatility is not reduced, it has likely increased, but a tradeoff results. While the “index bubble” inflates the market, as long as active managers are around, true and accurate price discovery will be at work.
One big concern of the study focused on the concentration within the asset management industry that has resulted from the index trend. Two firms dominate the business – Vanguard and Blackrock – sharing 80% of the assets of the top five firms as of March, 2018. Fidelity introduced a “no fee” index last summer as a response and is taking some market share, but to quote the Federal Reserve report “a significant idiosyncratic event at a large firm could lead to massive redemptions”. Further on, they worry that “large sudden redemptions could result in fire sales with broader financial consequences. In particular, operational events such as a cyber-security breach could pose such risks”. For you and me that means we will be dealing with more computer security requirements, such as more complex and confusing password requirements (my new pet peeve). But I guess we can tolerate this if it results in safer markets.
Finally, the report analyzed co-movement of asset returns and liquidity. Co-movement and correlation are cousins and we need to understand how indexing effects them. Unfortunately this area of study is extremely challenging and subject to debate. Studies show co-movement may make markets more vulnerable. However, the Fed study concludes “the evidence on trends and causality is mixed”. In other words, they are going to keep examining this area of concern. In my opinion, we should continue to diversify our investments but keep a keen eye on the benefits and costs of “spreading risk”. Perhaps some assets are not worth the extra cost of diversification any more.
Let us celebrate the tenth anniversary of the market’s rise with some basic truths. The market rewards patient and long term investors. Costs matter. Asset allocation and diversification are effective risk management strategies. I believe the discipline to build and maintain a portfolio focused on your goals matters more than anything else.
Our market strategist referred to Sacagawea this week. Sacagawea was a young Native American woman who earned her place in history by helping Lewis and Clark navigate America’s rivers to reach the Pacific Ocean. Let me suggest another Lewis and Clark reference: welcome to Camp Fortunate.
Ralph McDevitt March 6, 2019
For further information, please refer to:
“The Shift from Active to Passive Investing: Potential Risks to Financial Stability?”
Working Paper RPA 18-04, published August 27, 2018 by the Federal Reserve Bank of Boston Risk and Policy Analysis Unit.
Holding investments for the long term does not insure a profitable outcome. Investing involves risk and you may incur a profit or loss regardless of strategy selected, including diversification and asset allocation. Any opinions are those of Ralph McDevitt and not necessarily those of Raymond James. The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market. One cannot invest directly in an index. Past Performance does not guarantee future results.
