Index investing - cyclical and secular dynamics

Chas Craig, BridgeTower Media Newswires

In chapter 4 of “Investment, A History,” authors Norton Reamer and Jesse Downing discuss the commercial tailwinds for the mutual fund industry during the post-World War II bull market. They note that by the late-1950s market sentiment toward mutual funds had become exuberant, with the widespread enthusiasm reaching non-finance publications, such as Better Homes and Gardens, which declared in an issue around that time that “there is virtually no possibility that you’ll lose your shirt” by investing in mutual funds. Of course, the bear market beginning in 1969 put an end to what the authors described as “unfettered ebullience.”
Unsurprisingly, as losses piled up throughout the 1970s, public disenchantment grew. To this point, the book cites a Business Week issue noting that the mutual fund industry had developed “an image problem.”

As I recently read the passages summarized in the paragraph above it seemed to closely resemble the growth and evolving investor perceptions of passive equity investment products in recent years. The market share of passive U.S. stock funds has gone from about a fifth just before the Financial Crisis to about half today, and roughly 20% of the U.S. stock market is now owned based solely on index weightings. While it’s easy to cherry-pick anecdotes to prove a point one is trying to make, within days of reading the section of the cited book I was watching Jack Ryan, a popular military action drama. Ryan’s character, played by John Krasinkski, has a Wall Street background, and when asked by a commando for a stock tip, the star of the show blithely advices that the secret is to put your money in an S&P index fund. The point, a great many now believe that index investing has a monopoly on prudence. That worries me.

With one important caveat, that being their very low cost, I view index funds as providing similar advantages to investors that active funds provided in aggregate in the earlier era. First, even with a small amount of money, an investor can gain immediate diversification. Second, by entrusting your funds to a professional manager or focusing your holdings on only the country’s largest public companies via an S&P 500 index fund, the average investor is more likely to avoid rank speculation than if he were to go it alone.

However, it is important to observe that market cap weighted index funds, such as those that track the S&P 500, are effectively momentum strategies. To grasp this point, one must understand the mechanics of the typical index fund. In a market-cap weighted index, the larger the company, the larger its representation in the index. This means that as a company’s stock price increases the index fund is required to buy more of it with each new dollar that is allocated to the fund. Since the index fund community has enjoyed continuous and large inflows, their performance has benefited from the inherent momentum created by the market cap weighted nature of the index funds themselves. In the post-crisis period, with limited interruption, the stock market has marched upwards, making a momentum investing strategy a very rewarding one. This likely won’t always be so. Momentum can go the other way too.

With households’ equity allocations back near the high end of the historical range, it seems likely that at some point many investors will feel blindsided by market value declines in what they complacently thought were more conservative investment vehicles than is reality.

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Chas Craig is president of Meliora Capital in Tulsa (www.melcapital.com).