Are Index Fund Investors More Vulnerable to Bubbles?

One of the most superficially persuasive criticisms of passive equity index investment regards its susceptibility to bubbles and fads.  Indeed, this ‘vulnerability’ is an inescapable feature of market cap based index investing –  if a certain subset of the equity market becomes wholly detached from its fundamental attributes and extremely overvalued, an investor in a market cap tracker of that index will see their existing exposure increase and additional cash flows allocated in a greater proportion to this area.  The dot-com bubble is often cited as an example of a period when a simple passive market cap index investment was a decidedly poor choice.

Implicit in this criticism is the view that active management is better suited to this type of environment and avoids many of the aforementioned issues that would beset market cap equity index funds.  The problem with this line of thinking is that it only looks at one-half of the equation – focusing on what happens to index funds, rather than the probable behaviour of many actively managed strategies.

Let’s assume that a bubble emerges in a particular segment of the equity market and persists for a number of years before the ‘inevitable’ denouement.  We are aware of the implications for market cap passive investments – but what can we assume about the active management industry against such a backdrop?

– Active funds participating in the bubble areas gain flows and popularity due to strong performance.

– Many active managers abandon their philosophy and process to keep pace with market.

– Active managers avoiding the bubble assets lose assets / their jobs.

– Index aware / closet tracker funds increase exposure to bubble assets to manage tracking error.

– Fund selectors bemoan the relative underperformance of dogmatic managers for failing to adapt to the ‘new paradigm’.

– Money flows from active manager laggards to active manager outperformers. Fund investors crystallise recent underperformance and lay the foundations for future underperformance.

– Quantitative performance screens of actively managed funds uniformly highlight funds that have participated in the bubble as the most ‘skilful’ and ‘consistent’.

– Quantitative risk systems will show that active funds are running too much tracking risk by avoiding the bubble stocks.

– A minority of active managers will withstand the underperformance and remain faithful to their investment approach, but not without haemorrhaging assets.  This select group will be lionised as the bastions of active management after the reckoning.

Bubbles are formed by a compelling narrative, which is validated and emboldened by abnormally strong returns.  The notion that there is some great divide between the susceptibility of active and passive investors to such a scenario is spurious – even only on the basis that the active management industry makes for a reasonable sample of the market and therefore in aggregate will suffer in a similar fashion.

The idea that active managers will be standing steadfast against an irrational and unsustainable bubble that occurs in an area of the equity market – whist passive index investors blindly chase returns – runs contrary to the nature of bubbles, and the incentives and behaviours that have come to define much of the active management industry.  Furthermore, all of the evidence points towards fund investors heavily favouring recent outperformers – which will be those active funds that have embraced the new fashion.

Investment bubbles are alluring and persuasive, and it is only hindsight bias that comforts us that they are easy to identify and avoid.  As active management seemingly becomes increasingly myopic and focused on performance chasing / asset gathering, the ability to avoid bubbles reduces – if such a situation persists for any length of time most simply have to participate.

Of course there are exceptions to this – that select group of active managers that have a clear philosophy, operate in a supportive environment and hold a willingness to diverge markedly from the index.  These are the type of managers that fund investors should always seek out, but they are also the hardest to own, particularly in the midst of a fervent and sustained bubble, through which they will come to appear outmoded and unskilled.

In theory, any material and sustained detachment of an asset’s price from its fundamentals should prove a boon for active managers; however, this makes assumptions about time horizons and incentives that are at odds with the behavioural reality. There is no compelling reason to believe that passive market cap equity investors are more vulnerable to bubbles than their active counterparts.