Robert Young played the leading role in a 1960s television series called, Marcus Welby, M.D.. He played the role of Dr. Welby, a physician who knew his patients by their first names and always rendered the right diagnosis.
Robert Young once commented that he was surprised by the number of people that would ask him for medical advice. He was an actor. He knew very little about medicine.
Our minds play games on us. At some level, we know people like Robert Young know nothing about medicine. Yet, at a different level, if we are bombarded with a narrative long enough we find ourselves believing it regardless of whether it actually makes much sense. We actually think Ellen Pompeo (Grey’s Anatomy) might be a medical expert too. We wonder what Sam Waterston (Law and Order) might say about a legal matter or how Jon Hamm (Mad Men) might pitch our product.
The truth is these people are paid to be convincing imposters. Our brains are conditioned to think the image and likeness of the person playing the role actually knows something about the role he or she is playing. Would you send Tom Cruise on an important mission with a $65 million F-18 Hornet? Definitely not.
Such is the case with so-called passive investment strategies. We know at some level there is no such thing. Passive investing cannot possibly be passive. The person or algorithm picking the stocks just isn’t us. They are hidden from view. Stocks are chosen nevertheless and added to the portfolio.
We have been conditioned over the last twenty years to believe so-called passive investments carry lower risk than portfolios that are actively selected. People of stature tell us we can enjoy the benefits of equity returns practically for free at very low risk. People have told us this so many times that, like listening to Robert Young’s medical advice, we believe them. The fourteen-year bull market (only now showing signs of cracking) has only reinforced the notion.
Passive investing has become so popular that the top seven mutual funds in the U.S. by assets all purport to be passive funds. Four of those are tied in some fashion to the S&P 500. Don’t look behind the curtain, but every dollar that flows into a so-called passive investment strategy is actively invested in some stock.
What is it that makes passive investing so dangerous? When lots of people blindly invest in securities without regard to the value they receive in return, rest assured danger lurks somewhere close at hand. Investors have nearly a trillion dollars invested in those top seven mutual funds. Do they actually know what they own?
As we examine the market capitalizations of the S&P 500, we find five companies whose equities are valued at greater than $1 trillion. Apple is the largest at $2.2 trillion. Four of Apple’s top five shareholders are so-called passive funds, representing $445 billion of investment capitalization. Microsoft is the second largest company in the index. Its market capitalization is $1.9 trillion. Four of its top five shareholders are likewise passive funds with about $425 billion invested. Google comes in third with a market capitalization of $1.5 trillion. Four of its top eight shareholders are passive with about $130 billion invested.
Passive funds tend to dominate the shareholder registries of today’s mega-cap companies.
The vast majority of passive investing strategies are invested according to market capitalization. Every dollar that flows into an S&P 500 Index fund, for instance, gets allocated to specific investments based on the size of the company. The mega-cap companies like Apple, Microsoft, and Google receive the lion’s share of incremental flows into index funds. Companies too small to be in the index receive nothing. As dollars have been pulled out of active investing and into passive, the big mega-cap companies get bigger and the small companies get neglected. Passive investing, as a result, has become the mother of all momentum strategies.
We are staying away from the mega-cap companies that are being pumped up by passive investment flows. We are finding lots of opportunities in the smaller companies being neglected.
In When Hidden Risks Become Obvious we noted how risk grows and compounds largely unnoticed, then strikes like lightening when it suddenly becomes obvious. Once risk becomes obvious, the market reacts to the risk and it is too late to do anything about it. The time to protect yourself from hidden risk is when no one is paying attention. We believe now is the time to protect against the hidden risk of passive investing before those risks become obvious.
