SPDR ETFs: Passive bubble trouble?

Nov 28th, 2017 | By | Category: Equities

By Michael Arone, chief investment strategist of SPDR ETFs, State Street Global Advisors.

SPDR ETFs: Passive bubble trouble?

One of the most frequent questions I get from clients is “What do you think about the passive bubble?” However, asking the Chief Investment Strategist of State Street Global Advisors’ SPDR ETF business if there is a passive bubble is a little like asking a barber if you need a haircut – snip, snip. Of course there is no passive bubble!

In fact, over the last few months, collectively at SPDR, we have written a number of blog posts trying to dispel those nasty rumors. Yet, despite our best efforts, the passive bubble drumbeat has persisted, reaching such deafening decibels that I’ve had to wonder if I was missing something. After nights of tossing and turning – and plenty of objective evaluation – it finally hit me.

That buzz you hear is not the inflating of the passive bubble, it’s the massive unwinding of one of modern investing’s greatest bubbles: the active bubble. Let me prove it to you.

The good old days or too much of a good thing?

After decades where flows into active funds significantly outpaced flows into passive funds, an active bubble formed during the technology, media and telecom (TMT) era of the late 1990s and the early 2000s. Bubbles occur when a price surge that is unsupported by fundamentals is pushed higher by investors’ exuberant behaviour. When investors are no longer willing to buy at these elevated prices, the resulting selloff causes the bubble to pop.

Notably, bubbles generally aren’t identified as bubbles until they burst. Think back. In the TMT era, headlines focused on the new investment paradigm, while these classic signs of an active bubble went unidentified:

  • Irrational Investors: Investors’ thinking in the 1990s, now charmingly anachronistic, went this way: Why bother buying the index? For modestly higher fees, you gain access to the best asset management firms, genius portfolio managers and market-beating performance. Certainly, all that is well worth the incrementally higher costs.
  • Bountiful Initial Public Offerings (IPOs): In the 1990s, IPOs made early investors rich beyond their wildest dreams. There were 624 IPOs in 1996 and just 112 in 2016. During the dot-com peak in 1996, US listings hit a record high of more than 8,000 domestically incorporated companies listed on a US stock exchange.
  • More Actively Managed Funds: The number of active funds searching for the next best stock idea also skyrocketed in the 1990s, beginning a multi-decade upward trend. Interestingly, because a handful of active managers captured the majority of fund flows in the late 1990s, the same top 10 stocks were often held across many of the top-performing equity funds. So, when the TMT bubble burst, investors paid a big price for their lack of diversification.
  • More Aggressive Products and Strategies: Wall Street, never wanting to let a good bull market go to waste, created a host of new “innovative” and “disruptive” active strategies and products. Whatever happened to those 130/30 strategies anyway? Although there are nearly 10,000 hedge funds today, in recent years liquidations have outnumbered launches.

The price is right: Charting a new course with passive

Active strategies were portfolio linchpins when the TMT bubble burst and in the buildup to the global financial crisis. However, they did not protect portfolios in the ways investors had anticipated. Since 2007, investors have taken the opportunity to balance their investment allocations by smartly adding more passive investments, withdrawing nearly $1.2 trillion from actively managed US equity mutual funds and adding roughly $1.4 trillion to US equity index funds and ETFs. This trend has accelerated in the last few years.

Source: SSGA.

Yet, despite the differences in asset flows and the fact that there are more indices than publicly traded stocks, net fund openings and closures in ETFs versus mutual funds are nearly equal. That signals that active managers aren’t throwing in the towel and closing active funds.

Instead, a great recalibration has resulted in a better balance between active and passive allocations. As the proverbial pendulum swings away from active, the investment landscape is likely in the early stages of a multi-year transition from active to passive allocations.

Silver linings when bubbles burst

I see a strange irony in today’s worries about a passive bubble. As painful as it can be when bubbles burst, that Pop! often leads to a regime shift that corrects bubble excesses. Big picture, investors lost money when the TMT bubble burst, but those failed companies provided the foundation for today’s advanced digital infrastructure.

For investors, the soapy residue left behind when the TMT bubble burst got an organic cleanup underway. That is, the active bubble had a lot of warts that were exposed—from portfolios concentrated in a handful of pricey, winning stocks to high fund fees, exorbitant transaction costs, excess volatility, high portfolio turnover, tax inefficiencies and poor performance. In the aftermath, today’s investors have never had it so good. They have more choices and better information. Increased diversification and greater transparency. Lower fees and reduced transaction costs. Lower portfolio turnover and greater tax efficiency. Of course, the market is doing its part, too. Volatility is docile and absolute performance is soaring.

So where do we go with all this passive bubble talk? Passive investing has gained significant ground, but it has a way to go. According to the Investment Company Institute, 9,511 mutual funds held combined assets of slightly more than $16 trillion at the end of 2016. More than 70% of those assets are actively managed. Contrast that with close to 2,000 US-listed ETFs, nearly all managed to an index, with combined assets of roughly $2.5 trillion at the end of 20168 and 2,057 US-listed ETFs with $3.3 trillion in combined assets through October 2017.

Perhaps someday passive investing will reach bubble proportions. Until then, let’s relax and enjoy the fruits of the greatest active investment bubble bursting for a while longer.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)

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