tl;dr: YES. But it also depends what you mean by ‘good investment’
First, we can look at the claim that passive investing is a ‘bubble.’ Among those calling “Bubble!”, I see two separate groups making two slightly separate claims.
One group claims that incessant inflows of passive money are inflating prices of the largest stocks (AAPL, MSFT, GOOG etc.) which make up the largest part of cap-weighted indices such that they trade substantially away from an equilibrium fair value.
I think these claims are quite dubious. Prices are set by the marginal trade, and although I know little of micro-structure/market-making, markets are likely quite robust even to large amounts of so-called ‘uniformed flow’. To claim that the presence of such flow—even if it may have grown quite substantially—is distorting prices of some of the most liquid and scrutinized securities in the world for years on-end, requires substantial evidence. For now I mostly see handwaving and pointing to all sorts of valuation metrics from this crowd, with relatively little to show for it beyond that. (Disclaimer: the meta-contrarian in me is also broadly skeptical of ‘bubbles’ as a general concept. I’m partial to ideas that posit that both the dot-com boom and housing boom of the late-90s/early 2000s were far from bubbles qua bubbles, but that’s a separate discussion.)
The second type of claim is more along the lines of ‘passive flow has disrupted normal market functioning, particularly at a microstructure-level’. Here the claims are certainly both more speculative and more abstract. Claims here often appeal to complex-systems ideas, namely that certain feedback mechanisms will either cause a spectacular financial blow-up one day (killing passive by fire), or will drive markets to a permanent new equilibrium in which the Market Is Strictly Passive (killing active by ice). I’m not willing to entirely discount these ideas; however, the idea that active managers will be there to exploit potential passive-driven inefficiencies and bring markets back toward an equilibrium seems to be the more plausible base-case against which these more speculative theories have the burden to demonstrate superiority.
Here is where I will take a speculative turn myself and appeal to a macro-explanation of the passive phenomenon. Indeed, as others have pointed out, the last 10 years have been exceptionally strong for big tech stocks. Being long FAAMNG bettered just about every other macro trade out there in any asset class (save perhaps for being leveraged-and-perma-long German Bunds).
Coming out of the 2008 crisis, we had extremely high equity risk premiums, coupled with central banks not quite sure how to deal with the ZLB, and indeed there is compelling evidence that monetary policy perennially leaned too tightin many developed economies for most of the post-08 period. What results is a low inflation, low nominal growth, low interest rate environment, with broad corporate balance-sheet de-leveraging, which is particularly favorable for such near-monopolies like FAAMG, with their stable & moderately growing cash flows of extended duration.
Now in terms of maxing out favorable risk/reward per unit time spent deciding an allocation, it still looks quite difficult to top passive. But that doesn’t always mean a passive allocation to large-cap equities, 60⁄40 stocks/bonds, etc. will always be there to deliver.
My own (very speculative and tentative) view is that the next 5-10 years will not be nearly as strong for real equity returns as the last 5-10. For example, we have an FOMC that is taking active steps to commit to a more expansionary objective, at least attempting to make-up for undershoots in their 2% symmetric inflation target. However, the (current) level of discretion the FOMC appears to be favoring in terms of their reaction function has already lead some macro-historians to draw parallels to the ‘stop-go’ era of policy in the 1970s, which was a poor environment for financial assets of almost all types.
Intermediate-term, I think it’s likely that the post-COVID macro environment will be characterized by high, but relatively unstable expectations of nominal growth, which would reverse many of the macro-tailwinds that benefitted FAANMG so greatly this past decade. Of course, this is LW, so if there also appears to be mounting evidence that we’re about to transition to a new AI-driven mode of economic growth, a lot of this playbook gets tossed out the window :)
markets are likely quite robust even to large amounts of so-called ‘uniformed flow’
I don’t agree and would be interested in evidence for this. Have a look at what happened in 1999-2000 and see if you still think this. Investors moved en masse into hot tech funds, many “index” funds. The fund managers were to a large degree helpless as they had to follow fund mandates. Fund managers who stood aside as the madness grew lost funds under management rapidly.
”Indexing” is not actually indexing if you don’t own the whole market. That would include stocks, bonds and real estate in proportion to market value. You could start with an all world index fund like this https://investor.vanguard.com/etf/profile/vt and add an international fond fund and some get exposure to real estate all over the world (most REITs are more bond-like than real estate like).
If you are, say, in the S&P 500 only or over-weighted to the NASDAQ you are not indexing.
Good point and indeed indexing played a prominent role in the late 90s tech boom; it was a broad market phenomenon, in contrast to the idea that it was a micro-speculative frenzy contained to things like zero-revenue IPOs.
However, here I’ll expand on the meta-contrarian “bubble” point and offer that the dot com boom was not a case of markets gone haywire. I think we had a case for real technological prospects coupled with a market buying into the expectation that the Greenspan Fed was capable of providing nominal stability over the long-term.
It perhaps serves as a positive case study as to why some economists bang the drum so strongly for nominal GDP-level targeting. With expectations of nominal stability, the hurdle to invest in high-risk, long time-horizon projects, is greatly reduced. This can effectively yoink away much of the equity risk premium and could justify the high valuations and low expected forward returns to equity that marked the 1999-2000 period.
I’ll caveat by saying that this is currently just my working model of the late-90s, but it perhaps offers the deliciously contrarian view that managers just blindly dumping money into tech indices were actually not ‘uniformed flow’, even if they weren’t fully cognizant of the incentives they were responding to at the time
tl;dr: YES. But it also depends what you mean by ‘good investment’
First, we can look at the claim that passive investing is a ‘bubble.’ Among those calling “Bubble!”, I see two separate groups making two slightly separate claims.
One group claims that incessant inflows of passive money are inflating prices of the largest stocks (AAPL, MSFT, GOOG etc.) which make up the largest part of cap-weighted indices such that they trade substantially away from an equilibrium fair value.
I think these claims are quite dubious. Prices are set by the marginal trade, and although I know little of micro-structure/market-making, markets are likely quite robust even to large amounts of so-called ‘uniformed flow’. To claim that the presence of such flow—even if it may have grown quite substantially—is distorting prices of some of the most liquid and scrutinized securities in the world for years on-end, requires substantial evidence. For now I mostly see handwaving and pointing to all sorts of valuation metrics from this crowd, with relatively little to show for it beyond that. (Disclaimer: the meta-contrarian in me is also broadly skeptical of ‘bubbles’ as a general concept. I’m partial to ideas that posit that both the dot-com boom and housing boom of the late-90s/early 2000s were far from bubbles qua bubbles, but that’s a separate discussion.)
The second type of claim is more along the lines of ‘passive flow has disrupted normal market functioning, particularly at a microstructure-level’. Here the claims are certainly both more speculative and more abstract. Claims here often appeal to complex-systems ideas, namely that certain feedback mechanisms will either cause a spectacular financial blow-up one day (killing passive by fire), or will drive markets to a permanent new equilibrium in which the Market Is Strictly Passive (killing active by ice). I’m not willing to entirely discount these ideas; however, the idea that active managers will be there to exploit potential passive-driven inefficiencies and bring markets back toward an equilibrium seems to be the more plausible base-case against which these more speculative theories have the burden to demonstrate superiority.
Here is where I will take a speculative turn myself and appeal to a macro-explanation of the passive phenomenon. Indeed, as others have pointed out, the last 10 years have been exceptionally strong for big tech stocks. Being long FAAMNG bettered just about every other macro trade out there in any asset class (save perhaps for being leveraged-and-perma-long German Bunds).
Coming out of the 2008 crisis, we had extremely high equity risk premiums, coupled with central banks not quite sure how to deal with the ZLB, and indeed there is compelling evidence that monetary policy perennially leaned too tightin many developed economies for most of the post-08 period. What results is a low inflation, low nominal growth, low interest rate environment, with broad corporate balance-sheet de-leveraging, which is particularly favorable for such near-monopolies like FAAMG, with their stable & moderately growing cash flows of extended duration.
Now in terms of maxing out favorable risk/reward per unit time spent deciding an allocation, it still looks quite difficult to top passive. But that doesn’t always mean a passive allocation to large-cap equities, 60⁄40 stocks/bonds, etc. will always be there to deliver.
My own (very speculative and tentative) view is that the next 5-10 years will not be nearly as strong for real equity returns as the last 5-10. For example, we have an FOMC that is taking active steps to commit to a more expansionary objective, at least attempting to make-up for undershoots in their 2% symmetric inflation target. However, the (current) level of discretion the FOMC appears to be favoring in terms of their reaction function has already lead some macro-historians to draw parallels to the ‘stop-go’ era of policy in the 1970s, which was a poor environment for financial assets of almost all types.
Intermediate-term, I think it’s likely that the post-COVID macro environment will be characterized by high, but relatively unstable expectations of nominal growth, which would reverse many of the macro-tailwinds that benefitted FAANMG so greatly this past decade. Of course, this is LW, so if there also appears to be mounting evidence that we’re about to transition to a new AI-driven mode of economic growth, a lot of this playbook gets tossed out the window :)
I don’t agree and would be interested in evidence for this. Have a look at what happened in 1999-2000 and see if you still think this. Investors moved en masse into hot tech funds, many “index” funds. The fund managers were to a large degree helpless as they had to follow fund mandates. Fund managers who stood aside as the madness grew lost funds under management rapidly.
”Indexing” is not actually indexing if you don’t own the whole market. That would include stocks, bonds and real estate in proportion to market value. You could start with an all world index fund like this https://investor.vanguard.com/etf/profile/vt and add an international fond fund and some get exposure to real estate all over the world (most REITs are more bond-like than real estate like).
If you are, say, in the S&P 500 only or over-weighted to the NASDAQ you are not indexing.
Good point and indeed indexing played a prominent role in the late 90s tech boom; it was a broad market phenomenon, in contrast to the idea that it was a micro-speculative frenzy contained to things like zero-revenue IPOs.
However, here I’ll expand on the meta-contrarian “bubble” point and offer that the dot com boom was not a case of markets gone haywire. I think we had a case for real technological prospects coupled with a market buying into the expectation that the Greenspan Fed was capable of providing nominal stability over the long-term.
It perhaps serves as a positive case study as to why some economists bang the drum so strongly for nominal GDP-level targeting. With expectations of nominal stability, the hurdle to invest in high-risk, long time-horizon projects, is greatly reduced. This can effectively yoink away much of the equity risk premium and could justify the high valuations and low expected forward returns to equity that marked the 1999-2000 period.
I’ll caveat by saying that this is currently just my working model of the late-90s, but it perhaps offers the deliciously contrarian view that managers just blindly dumping money into tech indices were actually not ‘uniformed flow’, even if they weren’t fully cognizant of the incentives they were responding to at the time