Many investors enjoyed a rewarding 2019 in the equity market. But the dream run came to a shuddering stop during March. Since market circuit breakers were introduced in 1987 trading has only ever been halted five times, and that includes the four halts called in the past fortnight.

Even before the coronavirus pandemic struck, various metrics indicated a market bubble had been forming. The so-called Shiller PE ratio, which expresses a company’s share price as a multiple of its 10-year inflation-adjusted earnings, had surged past the crazy level it reached just before the great depression in 1929. The Buffet indicator – the ratio of total market capitalisation to GDP – in December 2019 was even higher than in 2000 when investors got carried away in the belief that the good times would continue for ever. 

Click on the image to enlarge. Source: https://www.multpl.com/shiller-pe

Illusions about the bull market were pricked by the protein spike carried on the coronavirus. But this time the bubble is bursting a little differently. Share markets went into freefall, with passive investment strategies underlying ETF investments exacerbating the market rout.

The active-to-passive shift

A passive investment strategy is based on the efficient market hypothesis, which argues that markets incorporate and reflect all relevant information, rendering stock picking and market timing futile. Warren Buffet thought this to be the case, betting with hedge funds in 2008 that, taking all the fees and costs into account, over 10 years an S&P 500 index fund would outperform hedge funds with hand-picked portfolios (Buffet won his bet).

The relatively higher returns delivered by passive investment strategies have been driving investor interest in this approach. Two decades ago, assets in actively managed US stock funds were 6.5 times greater than assets in index funds. But passively managed assets grew quickly, almost catching actively managed assets in 2019. 

Click on the image to enlarge

The merry-go-round of index investing

Investors needn’t spend the time and effort researching individual stocks if simply tracking an index is guaranteed to be rewarding. But are ETF investments really the silver bullet of investing? 

When a stock becomes large enough to join a cap-weighted index it gets even more capital thrown at it by passive strategies tracking that index. It incentivises investors to keep throwing capital into ETFs without making the effort to investigate which companies are actually undervalued (or conversely, overvalued).

And when a stock shrinks and falls out of a cap-weighted index, it gets sold down further by passive strategies necessarily forced to exit the stock. This reflects the so-called “Matthew effect”, where “the rich get richer, and the poor get poorer”.

When the cycle is reversed

But the self-reinforcing cycle of passive investment could backfire. Such a feedback loop could drive asset prices to deviate from fundamentals in the long-term, fuelling asset bubbles and stoking investment fever. When a black-swan event occurs, a bubble is doomed to burst. 

The coronavirus outbreak threw share markets into reverse. As pessimism infused the markets, investors in ETFs rushed to redeem. Selling an ETFs requires selling all of the ETF’s underlying index constituents, regardless of an individual constituent’s good or bad performance. This caused the index to fall further, in turn encouraging further selling.

The reverse of the cycle happened so violently that almost all the investors had their equity portfolio shrunk by 20 to 30 per cent in just two weeks during March.

Weighing the true cost of passive investing 

The increasing prevalence of passive investment strategies amplifies the volatility of stock markets when a tail event happens. It also gradually undermines the necessary process of value discovery in the market. This is somewhat paradoxical, as the passive investment strategy is rooted in market-efficiency theory.

The market crash triggered by coronavirus is perhaps a wake-up call for lazy or misinformed investors, reminding them there’s no silver bullet when it comes to investing. These investors may have enjoyed investing in 2019, but making money with no real effort is, in a sense, analogous to consumerism – there’s no need to defer gratification if a passive investment strategy is “guaranteed” to generate positive returns. But there will be a cost in the long term.

This could also the opportunity for active fund managers to prove their value and 2020 could be a tipping point where the active-to-passive shift reverses.