How Passive Investing Could Change Capitalism

the sort of basis of passive investing, which is index construction. Right. If you're going to invest passively, you need to be investing essentially in some sort of index or benchmark exactly, right. So you could say, oh, I'm not going to make any choices in my investment, I'm just going to invest in the market. But even that has to have some definition. If it's the SNP five hundred, then whoever designed the SMP five hundred is ultimately the one constructing your portfolio.

So ultimately someone is making a decision, even if you think you're sort of trying to take human discretion out of the process. Right, And there's really been an explosion in all types of indices recently, sort of growing in tandem with the big growth that we've seen in passive investing in general. One thing that gets bandied around quite a lot is that there are now more indices in the world than there are individual stocks, which, you know,

stop and think about that for a moment. It's it's pretty amazing, although I guess, you know, you could say, given the amount of stocks available in the world, there's sort of an infinite number of combinations that you could get at that point. But it does suggest that something that was supposed to be a simple reflection of a particular market has sort of morphed into something else, right.

I think Bloomberg uh Eric Belcoon has had a really interesting column this week, you know, pointing out that, you know, there's only really twelve notes on an octave, but there's hundreds of millions of songs, and I think that's a pretty good analogy for the relationship between individual components and indexes. And of course there's essentially an infinite number of ways that you can arrange them and wait the components and

wait them by size or factor or whatever. So it's not surprising that there is an incredible amount of interest and important place on a index construction these days, right, and people thinking about this indexation kind of issue or explosion and indices, it tends to either be of of that sort of ilk where people think, oh, well, it's it's natural that this is happening because we have these different varieties of indexes that you can build using different

types of stocks. But there's another extreme dream end of this, and you know people who actually find it quite worrying and quite dangerous for one reason or another. End. Today we're going to be speaking with someone who is firmly at that end of the discussion. I can't wait. This is a really important topic. I joked in the beginning that is there any other type of investing besides passive because it really does feel like that is swallowing everything.

And I think there's a real existential question about the role of what used to be called discretionary investing. And so I think there's it's a great it's a great timely and timeless topic for us. Yes, indeed, all right, So without further ado, our guest for this episode is Intego Fraser Jenkins. He is a quantitative strategist over at Bernstein you may remember him listeners as the guy who wrote The Silent Road to Serfdom why passive investing is

worse than Marxism. So, I promise this is going to be an interesting discussion. And Ago, thank you so much for coming on, but thank you for having me on. So and I guess my my first question is you've written quite a few notes about indexing at this point in time. Your latest one is sort of unusual in the field of analyst research. You know, it was called fund Management Strategy the man who created the last index, and it's sort of a fictional slash historical look at

index creation. How did you focus on this particular topic. Yes, so, when we think about the way investment works at the moment, I think this five trillion switch from active a passive has taken place in last decade is one of the biggest changes that we've seen, and I think that passive as a lot of further to grow. I think that some people have interpreted some of our previous work, because that's the one you just mentioned earlier, as us being

anti passive in some way. I wouldn't describe myself anti passive because passive is and more to democratize access to capital markets than any other invention in investing in the last couple of decades. But it does change the calculus for investors, both at the micro level, for an individual investor and for society overall. And so if an individual investor, there's a question of how active and passive interact with each other in their overall holdings. For society of all

are big implications for capital allocation and for stewardship. And I think that what it all comes down to is the relationship between a fund buyer and an asset manager is changing and as further to change, and that's been driven to something sent by the increase in passive options that are out there. Now you mentioned we've written about this in research notes in the past. We want to say a bit bit different here by writing a work of fiction, um, I mean, firstly hopefully a bit more fun.

It allows us to use kind of language is not possible in a normal style side research note, but also allows us to approach the active assive split from a few different perspectives. Where do you see this showing up? So it's one thing to talk about changes in governance, it's another thing to talk about changes in capital allocation and how that goes about. But when you look at the market, you still see some stocks doing well. You

still see some stocks doing badly, some companies thriving. Can you point to something happening in the market that's sort of independently observable and say, okay, here is a change in the way markets behave that we can associate with all the money leaving active and flowing into passive. I think the biggest issue here is just it's a question of what an investor expects to get out of an active manager, and I think we've seen some miss beans have blown up about that in the last decade or so.

So the idea the one could charge for beta as as an active manager UM has been obviously deep anked some time ago with the role of passive broad index funds. I think the next stage really is the idea of charging for factor beta in sense active managers who are actually just consistently hugging some factors in the market, well, and now you can buy those factors the current going

rates four basis points. I think smart beta will be free within a year or so, based in terms of headline fee if nothing else UM, And so that really kind of focused attention on on what the point of an active manager is, and so I think that's where the biggest change comes here. I think there's been perhaps a mistaken belief that because it's very easy to measure headline fee, that has become the key determinant in so

many fund allocation decisions. And when you look at the allocations both with an active and with impassive in the last few years, more than a hundred percent the net flow has gone the cheapest of active funds and the

cheapest of passive funds. Now, on one hand, that's great, and it's allowed asset owners to lower their overall cost of employing asset managers, But headline fee only really matters to extent that it influences the quality of the net of fee outcome, and I think that there needs to be a focusing on the minds about what kind of

outcome people want from investment decisions. Um and this sort of just fit into a much bigger picture, which is last thirty five years, Exus and got Up bonds have gone up, and they've managed to do so in a way that's given a negative correlation between them. So an extraordinarily benign set of circumstances, and that's as least been part of the reason why at least of the hindspee made sense for people to allocate from acts of the passive.

I think that if one projects forward from here and says, well, there are a number of reasons to suspect that what might be in a lower return world across asset classes um and it raised the question of well, what is the outcome people want? What is the real benchmark that investors care about? That real benchmark probably ultimately comes down to trying to fund retirement, healthcare cost, school fees, etcetera. All those things trade more like CPI than like a

capital market return. The question is, can um asset owners come to active managers and buy a return stream the net of fees will beat that UM. That in my mind's an active decision, but it's been somewhat subsumed by everyone assuming that the right thing to go and do is to hire a series of active managers who can perform a relative to a very specific benchmark in a

series of pigeonholes across the market. Mhm, So could you maybe step back for a second and describe how we got from you know, a sort of a relatively simple or simpler place where we had the Dow Jones index. I mean, when the Dow Jones index was invented, it had I think something like a dozen stocks in it. And now we're at this place where we have hundreds, if not thousands, of different industries and benchmarks of all different types of flavors, smart, beata, factor investing, whatever you

want to call it. How did we actually get here? Yeah? So, um. In the background to doing this note, was spent some times reading the early work of Dow and Paul and it's kind of fascinating to see the motivation behind the work that they did. Um. The work of down Poor was firmly in the camp of financial journalism, not in

the camp of investing. UM. So people may complain about price witted industries, but it was perfectly sensible decision for Dow if he wanted to report on the movement of the market the day before, seeming to add up prices and divide them by the number of stocks that he was using apartment anything else. Without modern calculating machines, it was hard to do that work any other way. UM. And that was a fair way to give a sense

of broad market movements. You can go back before that, the work of Poor and his work on the history of railroads in the US. It doesn't seem like ones reading a work of an index constructor when one picks up that book. But I would argue that one is because he has this massive enumeration of facts, which in this case miles of new track laid each year and

dividends paid by railroad companies. And it's basically a prose version of an index, I would argue, I guess as one roller clocks forward, the question of indexing became kind of critical for solving the agency problem, which is always inherent. If one goes out and hires an asset manager to run assets for you, how do I know I'm getting good value for money from this asset manager. How do I know they're doing something for me that I couldn't

get more cheaply somewhere else. And of course that's become a very broadly embedded as the as the idea of needing to perform a board market index, and that's driven the initial role of passive um. But once one accepts that idea that an index could be a rules driven approach to selecting kind of companies, as you said in your introduction to this piece, then suddenly the possibilities are endless.

And who's to say that a given definition of broad index is the benchmarks people have and there are a massive number of other ways of doing that. The question, I think, then becomes confused about whether one is right in a given circumstance to get rid of an active manager and replace them with a passive manager, which you know that would be the right thing to go and do if that active manager was doing nothing other than

hugging a passive index. But that gets confused with a broader question of well, what is the end outcome that people want to have? And I think there's been almost a inversion in the direction of causation, if I can say that, in the way people think about industries. The initial industries were there to report on what had happened

in the market the day before. Now the construction of new induseries, particularly on the smart beta induseries, are actually directing capital allocation um and become a the essentially a forward looking a guide to where equity capital goes. Right. I think about this a lot. So you know, we're talking about smart beta, So for people who aren't necessarily

familiar with it. This idea that there are factors within stocks that by some sort of researchers have you know, characterized out performance, whether it's stocks that are cheap on a pe basis, or stocks that exhibit high levels of momentum, things like that. And so this idea is that, well, why not just invest in a E T F for an index that capture all those things, and don't you

don't have to do the work. One thing I wonder about is like, Okay, you make a interesting and important point that the issue for investors shouldn't be fees per se, but that return negative fees. That still raises the question of that even if there are active managers who can deliver superior performance negative fees, does the individual investor have any way to identify them? Um. I think the investor needs to be clear about what kind of return stream

they want from their active manager. So I think it's normal for people nowadays to think about a manage has been a good manager if they deliver a return that exceeds that of the index. But of course, if one goes to a manager, one's buying a whole bundle of return streams all wrapped together in what their fund produced is Some of that's a market beata. Some of it will happen to be factors as you outlined just earlier

than to inform of smart beta. Some of it will be very stock stetific decisions that the manager has made. I think that one really important change is happening is by smart beta or these sort of simple factors essentially becoming free or something close to that. It really focused attention on what one should get out of an active manager, because it's always impossible for more sophisticate investors, say, to disentangle the kinds of return streams that they've had from

the fund manager. But it's been much harder to do that more broadly across the whole uh A space of fund buyers UM. And now the one can buy these factors essentially for free, A very important distinction gets made and one can say, well, it is manager giving me a return stream that is idiosyncratic, eye is different from UM this set of factors that I can buy. I think that's enormous important development because it allows us to say which kind of return streams become genuinely valuable for

the asset owner. Return streams you cannot get from simply holding a static combination of factors. So I'd argue that actually with UM, with the cheapening of in the season, the growth a more industries, maybe ironically, it's actually made it much easier perhaps to now identify what one would want from an active manager, and that is idiosyncratic returns. UM. Why is that not more reflected in flows into active

management then? Because you know, this is the discussion that comes up all the time with the explosion of passive investing. Most people would say, well, eventually passive investment is going to misdirect capital or misallocate capital, and there's going to be big price discrepancies that active managers can come in and exploit in some way, maybe by producing you know, idiosyncratic or specialized returns as you put it. Why aren't we actually seeing that play out in the market. Then? Yeah,

I think there a few reasons that. I mean, I guess the initial answer is that the entire focus of fund selection seems to be overly focused on headline fee. I mean, it's obviously very easy to ident for a headline fee up front ahead of time. UM, And I said earlier, UM, that has meant there's been a huge flow into the cheapest funds, both through an active and with impassive. UM. I guess another reason is that different

goes back ten years. Then, yes, it's true there were too many active investors who are charging an active fee for delivering something that was very close to the index. And it's right that someone has created a series of

passive indices and taken capital from those managers. I think where it gets more complicated, UM is that again, as I mentioned earlier, this has been an environment for thirty thirty five years when with hindsight, having a passive long only exposure to equities and a passive longer exposure to bonds has been not only good from a return perspective, is beaten CPI, but they've offered a diversification between them to go back of a longer horizon. That diversification is

actually quite unusual. UM. So I think that some of the support that passive has had has been a matter of circumstance and where we happen to have been from macro respective the last in a few decades, and that's going to evolve now negative but now inevitably it will take time for people to realize that we're in a new lower return world where bonds and equities aren't diversifying. That will take some time to be more broadly recognized, but when it does, it does change the calculus between

active and passion investing um. Also, the other thing I would just pick up on is your point about this discussion around does the market become inefficient in some way when there's so much passive that it creates perhaps unusually good opportunities for active managers. Well, I mean, in theory we can say that that's the case. I think in practice it's very hard to identify. To my knowledge, no one has managed to theoretically identify where such a limit

might apply. We don't even know if the relationship between amount of past investing um that exists in the market and the efficiency of the market is something that is a linear thing that simply gets a worse and worse over time as passive gets larger, whether there's some the tipping point. But we can say is the case of Japan where the penetration of past investing has gone away beyond the level that the US has got to, and

the Japanese market is still functioning. So I think we can say that we should expect more growth impassive to come um and that to identify a point at which there is where we should expect a mean version back into active, I think is very hard and something that's very far off in the future. I thought it was very interesting what you said about our faith in passive strategies as being somewhat dictated by the backdrop of markets over the last few decades and the inverse relationship between

stocks and treasuries. I think it is the same point made in our recent discussion with Chris Cole of Artemis Capital about expectations of volatility. I think it's been a consistent theme on this UH podcast. I mean Tracy said at the beginning, have we talked about passive and we

definitely have. But I do think that a consistent idea that we've heard a lot of people discussed from a lot of different angles has been this question of whether investors have been lulled into thinking that there's some strategy that's clearly the best strategy, but that it's only the best strategy in fact, because of the certain behavior of markets over the last few decades, particularly the relations ship between stocks and bonds, that has made that the best strategy.

So I'm curious if you could expand more on that and talk about why the way a lot of uh, you know, maybe individual investors or more sophisticated investors have their portfolios constructed. Why passive strategies may not thrive if there is a regime shift or if there is a relationship shift between asset classes. Yes, I think there's a lot of recency bias, which is hard to avoid for good reasons, um in lots of financial research takes place.

I mean, I guess we could point to the last decade of a que dominating environment as giving rise to a series of interactions in the market that might not be normal, and as that comes to an end, uh, they may change. I think there's also recently bus in the longer run which the peers since the early eighties has been one of declining yields across after classes or deals have come down, bond deals have come down, there's been asset price inflation at the same time inflation has

come down as well. UM that's contributed to returns from stocks and bonds being much higher than returns are required to beat inflation. And this negative stock bond correlation as well, which is Unusually, if you go back over a couple of centuries, you don't normally see negative stock bond correlation, and only that's a positive number. And so I guess to try and put in perspective how important that is.

One again comes back the question of why people trying to to invest, and I think they're trying to invest to fund needs that they have with the set in the real economy. If the set in the real economy, it's more likely that inflation is a better benchmark for

people UM. And so when people want to assess to return from a strategy going forward, I think it's more likely that people are focused on inflation plus as a benchmark, or thinking of absolute outcomes UM, so guaranteed outcome or a hard outcome target UM such as five percent or six percent, as being a return that people should expect UM. Now that's not to say that I'm barish on the

stock market. UM. The bid does not require UM start to go down to focus people's minds on the market in this way, but from a shillipe in the low thirties it does strongly imply subpar returns many years in the future. I briefly mentioned this in your intro. But I'd be curious. You know, the note that you wrote, why passive investing is worse than Marxism that got a lot of attention at the time and certainly cropped up in a bunch of different financial media. What was that

like for you? Like, what sort of feedback did you get from from clients or or readers. Uh, and maybe even you got some backlash from index providers. I don't know what was what was the reaction? Yes, certainly surprised by the scale the reaction, I have to say. Um. I think the feedback I got if many people was that this is a topic that people were concerned about and it and it often falls been the planks of the way the research is conducted. UM. Certainly in terms

of reach on the south side. People don't normally write about business strategies U on the buy side, UM. And so it certainly spoke to a lot of the concerns that people had. I think. UM. Also it finds some agreement from people in NASA management companies who have been trying to engage with policymakers and trying to make the case.

So there are some strategic issues at stake here Aside from them the more specific issues around an individual fund um and whether an individual asset owner should buy an

active or passive fund in that particular case. Maybe you can just sort of quickly summarize your argument because in talking to you so far as you said, you're not really anti passive per se and you point out that we don't know where the tipping point would be, that in Japan the share that goes to passive is much higher than it is here in the Japanese market still more or less function fine. So for those who haven't read your note, which is most people, what does that

mean worse than Marxism? How would you describe it? And I would not be surprised if the media distorted your argument in someone um. Well, the argument is quite a simple one, which is simply to think about how capitals allocate in society. So it's the worst of Marksism is definitely not from the point of an investor. It's from the point of view of society, of rule and the role of capital allocation in society. So I thought about investment outcomes, per se Um, and I can think about

three different possible types of society. One a fully capital society where people make very active as allocation decisions. Another marks of society where someone is given the job centrally to plan how capital is allocated. Uh. And then a third possibility, which should be a sort of fake capitalis society if you like, in which the capital allocation is done on a sort of passive trailing basis. So companies that have done well simply are accorded bigger weights and

equity indusseries. And I guess the pushback on it um and there's been various forms of it, but one of the main forms of pushback was the idea that do companies actually need to raise equity? If we're in a capitalite economy where the growth, especially coming from more service based industries, how important is the capital allocation process from active investors? And I'd argue that it is still important. I mean a because there is still a range of the of corporates in the market it that do need

to raise capital. Secondly, even if the company is not raising equity capital, often they want credit or bank loans, and that becomes cheaper if they have a share price

that reflects all the information. And Thirdly, they want to pay employees, often through stock if that's possible, So is the argument that basically capital is being allocated in a way dictated by index providers UM well merely to make the point that as new kind of capital um and is invested, UH, there are reverse ways of thinking about how that is directed to corporate um and one can either take a very active decision to say, well, a

certain company has certain growth prospects determined by its fundamental outlook or its role in society overall, and accorded to certain evaluation and allocation of capital accordingly, or else it is simply grown to be a certain size of a market, and therefore, as new the capital comes in to an index that that company is simply accorded extra value purely

because of the size it's reached in the index. Already, I want to ask about what it will take for active management to make a comeback, essentially, and to for managers to convince investors that there's more to life than just the upfront fee. And something I've been thinking about this year is that we have had these periods of volatility in which the relationship between stocks and bonds that we've been talking about has not in fact held up

the way people might have expected. Whether it's the February volatility or volatility this fall, and yet when I look across the landscape, I don't exactly see active management appearing to have done all that well. To be honest, and I know that you know, it was a pretty brutal month for many hedge funds. I think November was pretty

awful for them. So I'm curious why haven't we seen this year more examples of active managers saying, ah ha, this is what you pay us for because we can deliver in times like this and then be just what the general strategy will be for the industry to not

keep bleeding A m yeah. Um. So I think that's certainly apparent from conversations have had with active managers over the last few years that a few people have taken a view what we really need is a big draw down in the market and that will separate active and passive. And my response always been, will be really careful what you wish for, because the two thousand and eight period was not a happy one for many active managers, So I'm not sure if that is something that active managers

should wish for. It's not in a short term anyway. I think there is something that can be said about the potential for active out performance and the structure of the market, And by that what I mean is the performance of active managers tends to depend on how many independent bets they can put on in their portfolios. That in turn is a function of how correlated stocks are.

And we happen to have gone through a period in recent years where stocks have been other stocks been very correlated amongst themselves, and that's an environment where it's generally harder for active managers to perform. So if correlation came down between stocks, they we at some point arrived in a more benign macro environment and that would help. The other thing is the dispersion between stocks and how different

stocks are in terms of their valuation or their profitability. Again, if stocks are very dispersed in terms of their valuations, that then tends to help active manage performance. But all that really is just tactical and I think there's too much bigger things that would really help to drive the performance of active managers. And I'm not gonna try their performance, but but be the core focused their business models and

restore faith in the industry. One is this idea of if we really are in a low return world, and if the next five to ten years is one where capital markets can only slightly beat inflation, then asset owners are gonna have to come into active managers or managers in general, and ask for return streams that can fund their liabilities. I don't think there is any such thing as passive asset allocations, so I'm almost definitionally that generation

return stream has to be an active decision. Now, of course it can involve a passive instruments as part of that,

but overall it has to be active, I think. And the second thing is this idea that by the creation of so many indices, and by the cheapening of broad market um exposure and the cheapening of factor exposure in particular, it finally gives a new tool for asset owners to decide which kind of returns streams they should pay for and mass the owner who has scarce has to spend on ASID management services logically should spend them on a manager who can give a return stream which you cannot

get from holding a combination of simple factor strategies. Hence the idea that it's not the active share or the overall out performance of manager that becomes important, but it is how much idiosyncratic returns are they can generate. Him by that, I mean the returns that idiostyncratic to a set of factors that they could buy cheaply, alright Innego Fraser Jenkins of Bernstein Research, thank you so much for that.

That was great. Thank you for your time. So Joe, I found that discussion really fascinating and much more nuanced, perhaps than I would have thought based on the titles of his research. Yeah, I mean, I can't. He said he wasn't at the very beginning, that he wasn't act anti passive per se. But I'm sure it's understandable why people interpreted that he was if you're going to say

it's worse than Marxism. But I get his point that from a strict capital allocation standpoint, that the essential truth of based going based on the indices, which is that the indusicries are weighted towards size, and passive investing inherently will just reward yesterday's biggest companies. That that may be

one of the worst ways to allocate capital imaginable. Yeah, and there are some big picture questions embedded in that idea, one of which has to be you know, what is the stock market actually telling us if the price signal embedded in it is being so distorted by indexes and um, you know, these massive allocations of capital to the biggest companies. By the way, there are other people out there who

have had a similar idea to this. You know, Matt king over at City has talked before about how markets used to be self limiting in the sense that you'd get a bunch of money moving into one asset and eventually it would become overvalued and then money would leave that asset. But he argues that because we have so much passive investing, basically the market never self limits anymore, and you have inflows essentially following inflows. So you know,

this isn't necessarily a unique idea. Yeah, it's interesting to think about that. So obviously, anyone who's sort of maybe through a retirement plan just sort of throws money every month at a index fund that tracks the SPI is buying a lot of Amazon every month, and they're buying a lot of Microsoft every month, and they're buying a lot of Apple. It raises the question would they do that if they weren't just buying the index, or would they not keep throwing money and in fact the lion's

share of their money at the biggest company. So really like that idea we should get Have we tried to get mad on the show? We probably he's been on the show, we weren't. Yeah, well let's get him back on and talk about that time specifically. Yeah, yeah, we

totally should. Um And I just want to say, you know, I talked about a little bit, but I am fascinated by this how the relationship between stocks and bonds just keeps creeping up in our conversation, and how many different things going on in investing could change dramatically if intra asset class correlations were to change, and how many strategies that we think our sound inherently might end up being totally busted in a different environment one that could come about, say,

if inflation were to pick up. Yeah, it's definitely a recurring theme on this podcast. We should start an index called risk disparity disparity. Let's do it. We have a lot of projects. Okay, this has been another edition of the Odd Thoughts podcast. I'm Tracy Alloway. You can follow me on Twitter at Tracy Alloway, and I'm Joe Why isn't all. You can follow me on Twitter at the Stalwart, and you should follow our producer on Twitter tover Foreheads.

He's at foreheads t as well as the Bloomberg head of podcast Francesca leading at Francesca Today. Thanks for listening.