Nobody can predict the future, but there is a chance the blind purchase of broad-index portfolios will come to an abrupt and potentially chaotic end when the music finally stops. This argument is the thesis of this blog post.

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This article looks at decision-making trends in the context of security selection and asset allocation that may have significant implications for investors. In particular, there has been tremendous growth in broad market-cap weighted index investing (e.g. S&P 500) and automated rebalancing strategies (60/40-ish portfolios). These products are often purchased with little to no due diligence. Blindly purchasing an investment product is rarely a sensible idea. For example, one should consider the price paid (e.g., valuation) and the value received (e.g., asset quality). The separation of critical thought and an investment decision often serves as a necessary behavioral condition (perhaps not sufficient) that can lead to so-called bubbles (e.g., the Dot Com Bubble or the 2008 Global Financial Crisis).

Let’s dig into the Global Financial Crisis a bit further. In the build up to the crisis investors demanded investment-grade stamps but skipped due diligence. The word of the ratings agency was good enough — whoops. Trust, but verify. There are potential parallels with the current “passive” index investing frenzy (i.e., Beta ~1, mega-cap factor funds) as due diligence is often no longer a consideration and investors are placing their trust in efficient markets. In recent years, this has worked well for those employing the strategy. Broad passive indexes have crushed almost everything. Limited due diligence, incredible short-term performance, and a perceived “free” investment product.

What could go wrong?

To be fair, index products, such as exchange-traded funds (ETFs) can be great tools and help many investors (just like collateralized debt obligations or CDOs). However, there is a significant liquidity mismatch between the trading volume of some index products and that of their underlying securities. When index buyers and sellers are close to equilibrium, there may be no problem. However, if an imbalance develops and liquidity spills over into the underlying markets, then we may could see significant volatility if the tail starts wagging the dog (ETF supply/demand drives underlying stock prices, not fundamentals). (Wes has a good summary of the research on this topic here).

Figure 1: Index Products Dwarf Underlying Stock Liquidity

Blind Investing

Source: Aaron Brask Capital

This article focuses on the risks posed by a growing number of price-insensitive investors. It is divided into three primary sections followed by a conclusion.

  1. In the first section, I discuss problems I identify with broad market indexing and automated rebalancing strategies.
  2. Next, I draw parallels between investor price-insensitivity and credit crisis in the next section.
  3. Lastly, I present some numbers to put the risks into perspective.

Investing Based on Faith Can Cause Problems

There are two primary decision-makers in the typical investment process:

  1. The advisor who selects and maintains an asset allocation.
  2. The fund managers who select individual securities.(1)

In my mind, thoughtful due diligence should take place at both levels. However, there are strong trends driving many investors in precisely the opposite directions.

Figure 2: Investment Process Decision-makers

Blind Investing

Source: Aaron Brask Capital

Broad Market Passive Index Investing

To be clear, I am an advocate of sensible low-cost index investing; it is easy to do much worse than follow the broad market indices. Investors can get snagged in high-fee and opaque products, which are often the result of limited due diligence (the very issue we are discussing). However, I believe this specific type of index investing is approaching levels whereby its impact on share prices has moved from being “immaterial,” to material.

As I discussed in my article, Index Investing: Low Fees but High Costs (and briefly describe below), broad market index strategies do not employ any risk management approaches other than diversification. Even this is self-defeating, to some degree, due to the mechanical concentration in the largest companies via market-cap weighting. At the end of the day, passive index investors invest in all companies (good and bad) at whatever their prevailing valuations happen to be (cheap, fair, or expensive).(2)

The theory supporting broad market index strategies assumes the rest of the market participants are actively keeping prices more or less in line so index investors can get a free ride on their due diligence. There are merits to this argument, but there is also irony. In my view, the success and growth of these indexing strategies creates two significant issues.

  1. The first issue relates to the basic premise of relying on the rest of the market to keep prices in line. As the balance of index investors increases, there may be fewer investors left to conduct due diligence. While we are far from this scenario, even Vanguard founder Jack Bogle admits “If everybody indexed, the only word you could use is chaos”.
  2. I believe the second issue is more critical. In particular, the process of blindly allocating capital without regard for quality or valuation can reinforce and magnify mispricing. For example, consider a company that has become overpriced. In other words, its market capitalization is larger than it should be. This gives the company a higher weighting in the index.(3) As each new investment dollar pours into the index, more will go to purchasing the overpriced company than if it were fairly valued. This marginal extra buying pressure could then push the price higher. This process represents a vicious cycle whereby index investing can effectively reinforce and exacerbate overpricing. It is worth noting this phenomenon occurs regardless of whether we can or cannot identify which companies are over or underpriced.

Given the tremendous growth of the index investing industry, this is a legitimate concern. Vanguard’s assets under management reached $4 trillion this January. More concerning is that 20% of that figure was due to growth experienced in just the last three years. While it is one thing to invest blindly, I believe it is important to understand the mechanics of index investing and how they can impact the market (especially if these investors are not buy and hold forever investors).

Asset Allocation

Similar logic and reasoning apply to the hottest topic in asset allocation: automated rebalancing systems. Robo-advisors turn off the due diligence process and allow markets to take the steering wheel of their ruled-based investment vehicles. To be fair, many advisors embrace fixed asset allocation approaches. So this is not necessarily an issue with the new technologies for rebalancing, but is still emblematic of the more general trend of blindly following rules without considering the potential implications.(4)

At the heart of each of these strategies is the notion of diversification (defined with varying levels of sophistication). To quote Warren Buffett: “Diversification is protection against ignorance.” As I have discussed in previous articles, diversification is not the only tool investors should use to understand and manage risk. My point is simply that investors relying on diversification should still conduct a sanity-check on their investments for quality and valuation.

The Skinny

Given the extraordinary efforts of central banks in recent years, the prices and valuations of most assets have been elevated. We no longer have the luxury of investing in safe bonds with healthy yields on the order of 5% like we did before the tech

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