Follow the Leader – High Concentration Within Passive Investment Ve...

Now that we understand that passive funds are often labelled to mislead, why else might passive funds be a thing to lighten up on in our investment strategy?

Just look at the chart below. People have been dumping their money into passive funds (low cost, index funds and ETFs) at an accelerating rate since the 2008/2009 financial crisis.

“So what? This just shows that people were fed up with overpaid bankers and analysts and decided to go for the cheapest, safest, easiest-to-manage route.”

Sure. I agree that active funds are often overpriced and historically they do not beat the market consistently enough in order to justify their high prices. But let’s think about this…

Does it not appear that more than ever before, people are concentrating their investment capital into passive funds? Meaning, that more than ever before people are all buying into the same companies because most passive funds mirror the S&P 500?

Does it stand to reason then, that when the market inevitably corrects, all of these passive fund investors will be hyper-exposed to losses because they are invested in the same companies as everyone else, they are not properly diversified, and they will try to sell before their co-investors?

This last point raises perhaps the biggest red flag: everyone will be trying to sell before the price drops, or in other words, everyone will be selling.

Think of it like this: you are in a crowded movie theater and the fire alarm starts to sound. Whomever is nearest the exit will make it out first, but anyone after the initial exiters will have to compete for who gets to exit next.

This competition to exit (to sell the stock) will create an over-correction, meaning the stock will have such a high demand to sell that it will drive the share price down considerably more so than a calm, orderly, single-line exit.

There will be indiscriminate selling, similar to that of people pushing and elbowing to reach the fire exit to safety. Meaning, passive funds are primed for an over correction in today’s environment when a fire-alarm event occurs.

As we would imagine, the top holdings in most of these passive funds include the likes of Apple (AAPL), Alphabet (GOOGL) Microsoft (MSFT) Amazon (AMZN) and Facebook (FB), among others.

These stocks have undoubtedly performed extraordinarily well over the past several years and they are unarguably the companies leading the way for ______ (fill in the blank to your preferences). I put correction, but then yeah, of course, the future soon thereafter, hehe.

Just looking at the divergence of capital from active investing into passive investing, we can contribute a notable portion of these stocks’ extraordinary gains to a transfer of wealth into funds that hold these companies: passive funds.

Such a large transfer, in fact, that these companies went from being traded at about 10x earnings in 2008 to nearly 35x earnings in 2016. Refer back to the chart on capital flows into passive funds, notice any correlation?

This is not to say that the passive fund trend is single-handedly responsible for such high stock prices in these companies, but it is yet another variable to consider in a more complex market.

To “throw salt on the wound” for high stock prices, Amazon is currently trading at 183x earnings. Guess what? Amazon has no earnings, so they are really just trading at 183x what people think their earnings will be in the future. A bit of a stretch, no?

To be clear, I am not bearish on the companies highlighted. In fact, I am extremely bullish on the prospects for these companies. But in the world of investing, a quality company and a quality stock are two different things.

For the time being, I think these companies are priced appropriately for all of their “future” growth, meaning that they are extremely expensive. They also have the largest market caps in the world, so I do not expect exponential gains anytime soon by holding these stocks.

So, I choose to keep them on my watch list, and perhaps buy into them at any weakness.

“The biggest mistake investors make is to believe that what happened in the recent past is likely to persist. They assume that something that was a good investment in the recent past is still a good investment. Typically, high past returns simply imply that an asset has become more expensive and is a poorer, not better, investment.” — Ray Dalio

Follow the Leader – High Concentration Within Passive Investment Vehicles