The popularity of index funds and ETFs has risen exponentially since the financial crisis of 2008-2009, to the point where they now overshadow their actively managed counterparts on several fronts. This craze of taking money out of active funds and putting it into index funds has been driven by the reasoning that most fund managers fail to beat their respective benchmarks and that the fees one pays to put their money into an actively managed fund eats into the returns they do achieve. The allure of lower fees and better returns has in the past decade enticed a slew of investors, both retail and institutional, to pull their capital from active funds and park it into index funds and ETFs. One only needs to take a look at the ballooning AUMs of prominent index fund managers like BlackRock, Inc. (NYSE:BLK) and Vanguard Group to gauge the rapid pace of growth that index funds have seen in the last few years. However, this flight of capital from actively managed investment products to passive ones has come with its own share of systematic risks, something that the recent fourth quarter commentary published by Horizon Kinetics discusses in great detail.
Founded in 1985 by Murray Stahl, Horizon Kinetics is the parent company of New York-based Horizon Asset Management. The firm is known for adhering to a long-term, contrarian, fundamental value investment philosophy. In its latest market commentary, the firm devoted more than half of the document to arguing – along with facts and data- how ‘indexation’ is turning into an epidemic and could have a catastrophic outcome in the coming years. Though we can’t discuss in detail all the arguments the firm made against the indexation menace in one article, there are a few major points from that commentary that investors interested in index funds should ponder over before taking the plunge.
One of the major arguments that the firm made is that the large amount of money that has flown into index funds over the past nine years has pushed up the prices of ‘index-centric securities’. During the same time, the outflow from actively managed funds has compelled fund managers to sell what they owned, thereby creating a valuation imbalance between securities that are indexed and those that are not. Stocks (generally large-caps) that are part of an index have become overvalued, while those that not have become undervalued. Horizon Kinetics cites the five largest index managers as having, in aggregate, $6.1 trillion of equity AUM. Meanwhile, according to Siblis Research, the float of the S&P 500 is $18.377 trillion. Hence, the top-five index fund managers alone account for 33% of the S&P 500’s total float.
Another concern Horizon Kinetics raises is that until now, the flow of money has been such that it was getting out of active funds and was being invested in index funds. As long as the money has been coming in, the securities held by index funds have been appreciating in value. However, there is a threshold of the money that can come out of actively managed funds and data suggests that we are soon to reach that threshold.
“We do not know where the tipping point is. But the minute the inflows slow meaningfully, whether that takes three years or ten, the index will no longer set the price, the ETFs will no longer be setting the prices of the winners. At that point, the baton passes to the active managers, and they will set the marginal price. The remaining active managers, the Mario Gabellis and David Einhorns of the world, do not pay 22x earnings for mature companies like Procter & Gamble, nor 128x estimated earnings for growth companies like Netflix or 37x for a retailer, like Under Armour. At that point, the equity market might suddenly become quite efficient.”
The very theory on which indexation relies upon (i.e. markets are efficient and that over the long-term the benchmark performs better than any fund manager who tries to beat it) goes for a toss when one realizes that it’s the actively managed funds who make the market efficient by valuing securities. When the AUM of actively managed funds dwindles, there won’t be enough fund managers to keep the markets efficient by valuing stocks and placing trades based on that valuation. This will result in a bubble where the benchmark index and ‘index-centric securities’ will keep on going up until the crowd keeps pouring money into them via index funds.
“Index investors and asset allocators are caught in a logic trap. They have no mechanism by which to decide when or how to withdraw. Once one accepts indexation as the methodology for investing, it is like a trapdoor, because whatever the returns happen to be, the S&P 500 orsome other index, is the benchmark. Any return the index gets is, by definition, the return you should get. There is no definition of an inadequate index return.”
In the rest of this article we’ll take a look at the five major holdings of Horizon Kinetics and will discuss what the fund had to say about them in its recent market commentary, beginning on the next page.