Bubble Looming or Bubble Popped

It is safe to say that the word “bubble” is overused these days. The media bombards us with constant chatter of stock market bubbles, housing bubbles, student loan bubbles, and other financial bubbles when things seem to be going too well. Normally, these are things to be taken with a grain of salt because you really don’t know it’s a bubble until it has popped with the benefit of hindsight.

In fact, Rolling Stone once penned a somewhat controversial article in 2010 titled – The Great American Bubble Machine by Matt Taibbi¹. This article essentially painted Goldman Sachs as a great “vampire squid…relentlessly jamming its blood funnel into anything that smells like money.” The article went on to blame Goldman Sachs and its employees and former employees for helping cause the Great Depression, the dot-com crash, $4 gasoline, global warming, and the housing crisis in 2008. It is clearly a stretch to say that Goldman caused all of those problems, but Goldman did publically respond to the article with obvious denial.

This context is what makes a more recent article² on Goldman Sachs’ asset management business in Bloomberg Business on March 16, 2015 so interesting. In this article, Timothy O’Neill, Goldman’s head of asset management, had some interesting comments. He noted that Goldman is not interested in managing purely passive products, such as index funds or passive capitalization weighted asset class funds. In fact, O’Neill is quoted saying, “Trends in markets have a tendency to go too far one way or the other, and clearly the pendulum is swinging in favor of passive. But our belief is that market-cap beta, or passive indexing, is a potential bubble machine.”

Wait…What?

Before tackling his bubble machine comment, his statement that the pendulum is swinging in favor of passive is very true. In 2014, the two firms that added the most cash inflows into their mutual funds were #1 – Vanguard and #2 – Dimensional Fund Advisors, both historically passive managers. In fact, inflows to passively managed mutual funds across all asset classes were $420 billion last year, 10 times those of actively managed funds, according to Morningstar.

Why have so many investors moved into passively managed funds? We believe a big reason is because of actively managed funds’ historically dismal track record versus a relevant index benchmark. Standard and Poor’s produces a report³ each year called the SPIVA® scorecard, comparing all mutual funds to their respective benchmarks over one, three, five and ten-year periods. The results on US equity funds are below. When you compare them to their relevant benchmarks over all periods, the funds have a poor record of beating their index. In most fund categories, over statistically significant 10-year periods the index has won more than 85% of the time.

At Lutz Financial, we’ve espoused the benefits of passively managed assets relative to their active counterparts since our 2001 inception. We hope the recent realizations by the rest of the investment world are a result of investor education and better advising.  I don’t think it is coincidental that we are also seeing an increase in advisors moving from the traditional money center brokerages to become independent advisors.  With these moves, many are adopting the fiduciary standard of care towards their clients, instead of the more traditional stockbroker suitability standard.

So, is this increase in passive management a “bubble machine”?

I would hate to think that Mr. O’Neill is correct from a purely intellectual standpoint.  However, to answer the question as to a bubble we need to make a major assumption.  If investors have excess funds/savings to be invested into the markets, they have two ways of having it managed.   Essentially, investors are presented with the two alternatives – active or passive management (in varying degrees and funds).  So for the active manager, we could use Mr. O’Neill’s Goldman Sachs funds as the “active” alternative.  Well looking at that choice in depth, according to a New York Times article⁴ on April 12, 2015; during a 10-year time period only 12% of Goldman Sachs’ funds outperformed their assigned benchmark.  This data compiled by Morningstar also noted that Goldman’s funds also averaged 1.2% in annual internal expense.  So, if I can buy a fund similar to the benchmark with much less expense, why would an investor take the risk of trying to findhe headwinds actively managed funds produce for after-tax returns with excessive turnover which may the 1-in-8 shot that the fund they choose will outperform?  This is before even factoring in t generate both short-term and long-term capital gains.

In the end, my hope and thought is that it is less of a bubble occurring in passively managed funds and more of a bubble popping in actively managed funds as investors get smarter and focus on results instead of sales pitches.  Like any bubble, we only know with the benefit of hindsight, and I think those results speak for themselves.

¹ http://www.rollingstone.com/politics/news/the-great-american-bubble-machine-20100405

² http://www.bloomberg.com/news/articles/2015-03-16/goldman-predicts-growth-in-asset-management-unit-will-exceed-10–i7ch4zox

³ http://www.spindices.com/documents/spiva/spiva-us-year-end-2014.pdf

⁴ http://www.nytimes.com/2015/04/13/business/dealbook/wall-street-banks-mutual-funds-can-lag-on-returns.html?_r=0

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