Ned Davis: Passion for passive a ‘bubble’

As assets continue to pour into passive index funds, backlash from active managers has risen. The latest salvo against passive investing comes from Ned Davis Research in a recent piece by the firm’s founder titled “The Passive Investment Bubble.”

An estimated $282.8 billion has fled actively managed funds the past 12 months, according to Morningstar, Inc. A great deal of that flow has come from overwhelming evidence in recent years that relatively few actively managed funds beat their benchmarks, and even fewer do over the long term.

Mr. Davis writes: “‘Don’t worry about fundamentals, or values; don’t worry about market timing; just buy the market and hold!’ Even if there is a small correction, the market has always come back! Sounds ‘bubbly’ to me.”

Typically, bubbles are in asset classes, not in investment techniques: The technology bubble in the 1990s, the housing bubble in the last decade, the ‘Nifty Fifty’ bubble of the 1960s.

“This bubble has different aspects,” said Ed Clissold, chief U.S. strategist at Ned Davis Research. “The point is that the way people are investing is creating market dislocations.” In the runup to the 1987 crash, for example, investors thought portfolio insurance would keep their portfolio from getting crushed. During the Nifty Fifty period, people thought that if you bought good stocks, you didn’t have to worry about valuations.

During the dot-com bubble, only tech stocks were overvalued, Mr. Davis argued. Others sold at quite reasonable valuations. Mr. Davis notes that the average stock in the Standard & Poor’s 500 stock index is much more overvalued than it was in 2000 or 2007. “In my opinion, this is clearly bubble territory,” Mr. Davis wrote.

Passive investing allows investors to tap the entire universe of stocks at remarkably low cost. “What’s not happening now is that you don’t have an individual combing through balance sheets or talking to management,” Mr. Clissold said. “At some point, that should matter, too.”

Two points of hope for active managers: correlations between global asset classes and the S&P 500 are breaking down. Assuming managers can choose the correct option — a big assumption — lower correlations could give active managers some advantage. (Correlations between S&P 500 stocks are breaking down as well, Mr. Davis wrote).

Vanguard, which has been the main recipient of the trend to passive investing (and which offers a number of actively managed funds as well), recently posted a blog entry by Jim Rowley, a senior investment analyst in Vanguard Investment Strategy Group. The post referred readers to the annual S&P Indexes versus active (SPIVA) report. Only 8.09% of large-company stock funds outperformed the S&P 500 the past five years.