Very few people are tangibly aware of the risky nature of making an investment. With all the models and mathematics available for the mild-mannered meek seeking their fortunes has led people to believe that investing is a safe bet. It is as if the infrequency of financial collapse allow people to forget their eventuality. Yet surprisingly, the default strategy of an investor is not to invest for the future, but for the now. The now is the passive investment strategy, hugging the market index like mud on a pig, and making money by rolling over, and playing dead.
To be fair, there are benefits to choosing ETF index tracking investment packages (the holy grail of passive investment), namely that listings such as the S&P have demonstrated an overall upwards trend throughout the last 50 years, and that investing in these funds are a stupidly easy way to make some return on one’s investment. However, acting like sheep demonstrates no skill or knowledge, and to be honest, could be executed by a baby panda. Subsequently, this trend in Pro-Passive investments and Business cycle buggy hopping is actually demonstrating harmful effects on the infrastructure of modern economic, and all of the sheep may be leading the sharks towards a very dangerous cliff, through what is now known as the herd-effect.
Defined as the passive tracking of mass market indices, the herding effect allows for a cost effective means to create the reward with far more sheltered risk. At least that is how it is being advertised. In reality, there are three reasons for the use of market trackers. Firstly, this strategy avoids the high fees payed towards active management, and the research and effort necessary to find “winning” ideas. Since many investors do not have the skill or the knowledge to be able to outperform an index continuously, paying for the service does not equate to a god investment for many managers.
Secondly, fund managers’ (life assurers, pension, etc.) willingness to bear investment risk has declined dramatically in recent decades. The proportion of leveraged investments, investments that do not put an investor’s cash into harm’s way, has halved in the last 20 years (Jenkins, 2016). This demonstrates not only manager’s unwillingness to “play the game”, as the majority of this reduction coincides with the introduction of accounting standards and regulation in the last 10 years, but also that managers are over-adjusting for risk. When focusing on market volatility, current approach fails to distinguish between the risk of permanent loss and asset price volatility. When prices fall significantly, it is often a good time to buy, regardless of high volatility, following a “hit rock bottom” approach (Goldin, 2015). The fact being that most managers do not look forwards (or back), and simply “attempt” to predict the present.
Thirdly, managers have come to stress a need for liquidity in all investments. While for growing companies and funds access to cash is important, it is important to read the fine print. On November 8th, in the city where all eyes were on (albeit for a different reason), Mr. Cunliffe, deputy director of the Bank of England gave a speech on the increasing systematic use of ETF’s as the investor tool of choice to generate a revenue stream. In this 3 hour speech he gave, it became clear that Mr. Cunliffe was not a fan. “The industry (ETF Tracking) is now vast, with $77tn of assets under management, $30tn more than a decade ago. And the daily redemption promise that most funds give investors is increasingly inappropriate. With the search for yield, (funds) have become active in more illiquid and volatile markets while still in the majority of cases promising daily liquidity.” (Jenkins, 2016).
Yet besides the false advertisement, a greater con outweighs the pros professed by the passive investment movement. A recent publication by the International Monetary Fund stresses that the excessive reliance on regulators, accounting bodies and industry trackers have amplified market volatility, the availability of long-term funding for infrastructure and the effects of any economic crisis (Cipriani, 2014).
The reliance on these measures forces the adoption of a pro-cycle, short-termist outlook towards the investment strategy of most market makers. Particularly for pension funds and life assurers, who provide the crucial link to an equilibrium market by orienting towards long-term investments and smoothing out short-term volatility, this strategy has very sharp repercussions. The passive equity investment industry makes up currently a third of the US market. Due to its rapid inception, it has not really been tested, and it can be expected that theses ETFs will trade at a serious discount to net asset value in future down markets (Amery, 2016). Not to mention that the amplification effect on market volatility makes a very steep hole for these investors to climb out of once down.
Of course, ETF managers stress that these fears are overblown, and that ETF’s structure of secondary market liquidity and methodology of selling off debt in junk rated bonds protects most investors from liability. To recap, this is an industry that makes up a third of the US Market, offers returns that hug market indices, profess liquidity falsely, and sells of investor’s debt to other investors so as to protect from the risk of defaulting. Can no one else hear the screams of another ’08 style financial collapse?
Yet currently no one is making the first moves. Countercyclical capital buffers that rise and fall depending on the state of the economy would limit short term volatility and support investment risk-bearing throughout cycles would promote long-term investments (Goldin, 2015). A long term outlook that does not live and die by the whim of the people. The alarm bells are going off, yet even with a delay, investors can currently make money by following the markets. However, in the not-to-distant future, a bullish market will turn into a bearish one, and a lot of sheep will have ran off their cliff, dragging us all with them.