The Future Of Popular S&P 500 Index Funds

Isn’t this a wonderful quote from Seth Klarman’s 1991 cult classic “Margin of Safety”?

“…Another reason for the trend toward indexing is that many institutional investors and pension funds believe in the efficient-market hypothesis. This theory holds that all information about securities is disseminated and becomes fully reflected in security prices instantaneously. It is therefore futile to try to out¬perform the market. A corollary of this hypothesis is that there is no value to incremental investment research. The efficient-market theory can be expressed, according to Louis Lowenstein, “as a much-too-simplified thesis that one stock is as good as another and that, therefore, one might as well buy thousands of stocks as any one of them.”

By contrast, value investing is predicated on the belief that the financial markets are not efficient. Value investors believe that stock prices depart from underlying value and that investors can achieve above-market returns by buying undervalued securities. To value investors the concept of indexing is at best silly and at worst quite hazardous. Warren Buffett has observed that “in any sort of a contest—financial, mental or physical—it’s an enormous advantage to have opponents who have been taught that it’s useless to even try.” I believe that over time value investors will outperform the market and that choosing to match it is both lazy and shortsighted.

Indexing is a dangerously flawed strategy for several reasons. First, it becomes self-defeating when more and more investors adopt it. Although indexing is predicated on efficient markets, the higher the percentage of all investors who index, the more inefficient the markets become as fewer and fewer investors would be performing research and fundamental analysis. Indeed, at the extreme, if everyone practiced indexing, stock prices would never change relative to each other because no one would be left to move them.”

When it comes to long-term investing, there is a generational gap between those born from the mid-1980s onward and all the Americans that came before that.

For most of American history, the idea of investing money into specific corporations was the exclusive domain of the rich. In a world where mutual funds didn’t exist–you can argue about things like the Wellington Fund that were novel and existed at the margins–any common stock investing had to be done through round lots of 100 shares that usually cost thousands of dollars and often came attached to a three digit trading cost.

If you wanted to buy 100 shares of General Electric for $49 in 1960, you would have to fork over something like $5,200. You’d pay $4,900 for the stock, and then a trading fee of $300. Today, that would be the equivalent of going around and making lump sum investments in blocks of $29,000 increments. This did have the salutary effect of encouraging long-term thinking because the high frictional costs acted as a strong hurdle deterring whimsical stock selection, but it also carried the very negative effect of foreclosing the possibility of passive income generation through business ownership to the middle and lower economic class.

The 1980s, and mostly the 1990s, changed all of that with the rise of discount brokerage houses and a secular bull market that lasted from 1982 through 2000. According to the calculator, the returns from January 1982 through December 2000 were 17.01% annualized. This turned every dollar invested in 1982 into $19.78 by 2000. That’s what happens when you combine an unusually low starting valuation, a wildly high ending valuation, and unusually strong productivity gains during the measuring period.

The cultural consequence is that the investors of the 1980s and 1990s have a very fond reference point for investing–they could see how developing the knowledge to invest in successful corporations could lead to significant lifestyle upgrades. The adage “you only have to get rich” became a reality, as the time frame of realizing success became shorter. Everyone would be a farmer if you could plant tomato seeds and have a ripened garden a week later. When the beneficial link between cause and effect strengthens, it’s easier for a passion to develop. It’s no surprise that the overwhelming majority of people with interest in owning individual corporations were around to behold the stock market performance of the 1980s and 1990s.

People that have come of age in the past sixteen years and participated in the stock market haven’t had the same intoxicating experience. The bubble highs of 2000 created an unfortunate measuring period looking onward so that many stocks would necessarily be doomed to earn substantially less than their EPS growth rate because the overvaluation needed to be burned off. Then, you add the financial crisis which brought 30% declines to the best corporations and decimated part of the large-cap financial sector and it is easy to see why younger investors have not had a moment to fall in love with the investing process (that said, the March 2009-present day period has been one of the truly underappreciated bull markets in history, with stocks compounding at 17% to turn $1,000 into $3,000 over the past seven years).

With fewer people falling in love with the process of investing, you see institutions like Vanguard, Wealthfront, and Betterment grow in popularity as building wealth is only appreciated for the ends, but not the means. The enjoyment is turning $100,000 into $1,000,000, not the individual characteristics that enable the ten-fold increase to happen.

As a result, my hypothesis is that stocks belonging to the S&P 500 (or wherever the bulk of auto-invested money ends up) will have a high likelihood of trading at prices that depart from underlying fundamentals. Wonder why Exxon stock still traded in the $70s and $80s even as oil plunged below $30 per barrel? Because investors are mindlessly placing buy orders for Exxon stock by purchasing more and more shares of S&P 500 index funds.

The Vanguard S&P 500 fund seems to constantly be reporting record-breaking inflows. For January, there was an additional weekly inflow of $561 million that went towards the ETF with the ticker symbol VOO. That data point alone necessitates the purchase of $16 million shares of Exxon without respect to underlying fundamentals, but rather, the size of its position in the index. And that is just one weekly data point from one fund that invests in the S&P 500, and says nothing about the other indices designed for auto-purchases that contain Exxon as an index component.

There is nothing new about this theory. In 2000, Paul Gompers and Josh Lerner wrote in the Journal of Financial Economics that the textbook theory suggesting that all stocks are perfectly valued according to expected future cash flows discounted back to the present does not hold up, with their examination of venture funds concluding: “This finding suggests that the influx of capital positively influences the pricing of venture investments. The authors’ findings have interesting implications. First, research should be conducted on other market sectors that are subject to fluctuating capital flows (such as real estate and emerging markets) to determine whether capital flows affect their valuations. Research in these areas may add support to the authors’ results. Second, if capital flows by themselves influence valuations, then perhaps “hot money” flows are destabilizing, because inflows might lead to overvaluations and excess investment and outflows might lead to undervaluations and insufficient investment. Consequently, efforts to restrict hot money capital flows may be desirable on economic efficiency grounds.”

This doesn’t mean you won’t find deals among large caps–heck, I spent my first two years of writing heavily discussing the undervaluation of General Electric, Johnson & Johnson, and Bank of America, with the valuations of the first two converging to fair value and the latter remaining undervalued. But I think the bulk of opportunity ahead will reside in studying the small and mid-cap markets, where inefficiencies reign supreme due to underinvestment and a lack of willingness among the rising generation to spend time studying whether a $900 million corporation is really worth $2 billion.

People usually discuss this topic by saying “well, not everyone is going to index, so this problem is mute.” But that’s not the proper question to examine. Instead, it should be: Is there a trend suggesting that a critical mass of investors will focus on auto-investing into index funds that disregard fundamentals such that the valuation will be distorted by changing trends regarding inflows and outflows?

The “truthiness” of the efficient market hypothesis relies on the overwhelming majority of investors making pricing decisions about individual securities in response to the their appraisals of the fundamentals of the business itself. Any uptick in investor behavior that is not responding to fundamentals–such as auto-purchases designed explicitly to avoid spending a lifetime analyzing fundamentals–will in turn diminish the validity of the theory. Klarman nailed it when he said: “Although indexing is predicated on efficient markets, the higher the percentage of all investors who index, the more inefficient the markets become as fewer and fewer investors would be performing research and fundamental analysis.”

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