Normalised Interest Rates, Persistent High Inflation Risk, Unwinding of Excesses, Plausible Alternatives.
Passivity isn’t a recommended approach to superior performance in any field. But not in investing, at least for the past two decades. Passive investing has consistently outperformed active investing over the past quarter-century. Nearly 70 per cent of incremental capital flows to mutual funds and exchange-traded funds over the past twenty-five years have gone to passive funds.
The poor track record of actively managed funds is a major reason for the popularity of passive funds in recent decades. Despite their high costs and fees, active funds have consistently underperformed the broader market. Meanwhile, passive funds have delivered satisfactory returns for investors, largely because stocks have performed well over the past two decades; capital has always chased assets that promise high returns with the least possible risk. Active investment funds already had a poor reputation due to prolonged underperformance coming into the millennium. The better returns from index-tracking funds and the resulting high-water mark have further eroded active funds’ already tarnished performance and reputation.
Passive fund managers don’t analyse industries and stocks to identify the right stock for their portfolio. They find no merit in doing so. They are of the view that the time and effort that goes into these activities don’t contribute much value to the portfolio. Passive fund managers therefore invest in stocks that are part of major market indices such as the S&P 500, Dow Jones, and Nasdaq in the U.S., and the Sensex and Nifty 50 in India. They never concern themselves with the underlying fundamentals of the stocks they choose for their portfolio. There is no point in showing concern. So long as these stocks are part of the index the fund tracks, the manager is bound to hold them in the fund’s portfolio.
Both institutions and individual investors enthusiastically embraced passive funds. Institutions find the size, performance, low cost, and liquidity of passive funds suitable for their interests and objectives. For individual investors, it was the better performance, low cost, and endorsement by experts and consultants.
The bull market over the past two decades is a key reason for the widespread acceptance of passive funds. It is doubtful whether passive funds would have received the same level of acceptance in a volatile, challenging market as in the 1930s and 1970s, when markets went nowhere but swung widely. The principal enabler of the market boom over the past two decades has been the low global interest rates that have prevailed for most of the time since 2003. Interest rates were first brought low in the aftermath of the dot-com bubble burst; secondly, they were brought down to near zero due to the 2008 global financial crisis; and, thirdly, in 2020, in response to the Covid-19 pandemic.
So, the popularity of passive index funds can be attributed to the general market boom of the past two decades, whose genesis lies in the low interest rates that prevailed during most of this period. However, interest rates are no longer low. An inflation spike in 2021-2022 has forced global central banks to raise interest rates to more normal levels today.
Interest rates move in cycles. In the United States, it rose from near zero in 1945 to 18 per cent in 1981. That was the peak. From there, it began a long decline that finally bottomed at near zero in 2009 and stayed low until 2021. The high inflation episode during 2021-2022 forced central banks to sharply raise interest rates during 2022-2023. Interest rates in the United States range from 4 to 5 per cent today. It seems we are in that part of the cycle where interest rates are set to rise and remain higher for the long term. This is unwelcome news for equity investors because stock prices and interest rates are inversely correlated. Stocks have generally prospered during periods of declining interest rates, while suffering during periods of rising interest rates.
It is a misjudgement to justify current high stock valuations and return expectations by linking them to better economic growth prospects. Stock returns have nothing to do with economic growth. The period from 1945 to 1970 is considered a golden age of economic prosperity in the United States and the Western world in general; US economic growth averaged 8 per cent. However, inflation-adjusted general market return during that golden period was near zero, the culprit being rising interest rates, which climbed from near zero to 8 per cent.
We are currently in one of the longest-running bull markets in history. History has also shown, time and again, that all bull markets eventually come to an end. Will the current bull market, ignited and fuelled by low interest rates, continue uninterrupted in a period of normal or rising interest rates?
Fluctuations in interest rates and credit subject the economy and financial markets to occasional booms and busts. Some of these booms often escalate into manias, and when they do, they engender asset bubbles that usually end badly, with adverse effects on asset prices and economic activity. According to experts who have studied these manias and their causes, such manias usually originate in a displacement produced by a novel idea that promises significant productivity gains or a permanent solution to a long-standing problem. In most cases, these ideas do deliver benefits to society. Yet the excitement surrounding the idea causes people to harbour unrealistic expectations, and massive capital is invested on that basis.
Once the gains and benefits from the idea start to accrue, they usually fall short of people’s expectations. People then become sceptical about the feasibility of those expectations. That’s when the boom begins to unravel and turns into a bust. Asset prices inflated by excessively unrealistic expectations begin to deflate. Once the mania and bubble are busted, the idea and its benefits may remain in society. Still, most of the capital invested to capitalise on the opportunity shall be lost.
Although the stock market offers opportunities for high returns, achieving them has always been a challenge for most investors. Consistent, superior risk-adjusted returns have largely remained elusive for the general public. Against this backdrop, passive investment funds have emerged as a satisfactory and widely accepted solution. By delivering satisfactory risk-adjusted returns and outperforming most active funds, passive funds have delivered on their promise. But as enormous capital has flowed into these funds, there is a risk that excesses and bubbles may have formed in the frontline stocks – stocks that form part of the major indices and to which investors through index funds have directed enormous capital.
Excesses and bubbles are very likely when too much money flows into a specific sector or asset. The emergence of passive investment funds as a preferred vehicle for achieving better stock returns for both institutions and average investors alike in recent years is very likely to have bred, if not bubbles, at least some froth in frontline stocks. The market price of these stocks rises or falls not based on their underlying fundamentals but on whether they are added to or removed from an index and on the amount of money that flows into the funds that track the index.
A period of low interest rates has fuelled a stock market boom, leading to a boom in passive investing. As the principal driver of the boom – low interest rates – has ended, the time to correct the excesses it created is imminent. Perhaps the correction is already underway: money is quietly shifting away from passive investment funds to alternatives. Anyway, as interest rates rise, it is normal for money to move away from risky assets to safer ones.
Passive investing and low interest rates have been the norm for a long time. Habits and perspectives formed and held for a long time won’t change in response to changing external conditions. There is always a lag. We appear to be in a transitional phase in which mindsets and perspectives are gradually adjusting to the changed external conditions. The asset classes that will emerge as preferred alternatives in the new environment are hard to predict. Rising interest rates don’t augur well for both bonds and stocks. However, short-maturity bonds will come out better.
An idea whose time has come develops slowly. But once it crosses a particular threshold (the turning point) in awareness or acceptance, growth explodes; the growth rate shifts from slow to spontaneous. Most people are introduced to the idea at this stage, so it may feel like it came out of nowhere. For Artificial Intelligence, the turning point occurred on November 30, 2022, when OpenAI officially launched ChatGPT. The same can be said of an idea whose end is nearing. It fades slowly, then rapidly as the turning point is reached. Passive investing had its time as a suitable strategy for achieving satisfactory market returns for the vast majority of people. But its competitive edge has waned as interest rates rose to normal levels in 2022-2023.
The new investment idea or theme suited to the changed environment is supposedly already in place, quietly gaining ground, far from the mainstream. It catches fire once it crosses a threshold. Successful investing is about identifying the theme before it catches fire. Why can’t active investing be an appropriate theme for the new era? Finding superior stock ideas is not much of an edge when most stocks are delivering better returns. However, during a period expected to be challenging for most stocks, the ability to identify the few superior stock ideas that are likely to outperform the market is a competitive edge.
Value investing triumphing over growth investing is another theme that can play out in the new investment environment. During periods of low interest rates and high economic optimism, investment decisions are largely driven by a stock’s growth prospects rather than its valuation. This will reverse in the new environment. If high and rising interest rates characterise the coming period, valuation will be the primary factor behind investment decisions rather than growth prospects.
For a growth stock, most of its value lies in the future rather than the present. The reverse is true for a value stock: most of its value lies in the present rather than the future. Low-interest-rate periods are favourable for growth stocks, as their future earnings (where most of their value lies) are discounted at a lower rate. But as interest rates rise, these future earnings will be discounted at a higher rate, thereby exerting downward pressure on its market price. Meanwhile, value stocks won’t suffer as much because very little of their value lies in the future.
Passive investing will lose its current prominence, first gradually and then rapidly. The forces that might bring about this are already at work. Habits, beliefs, and perspectives that have been held, applied, and proven effective over a long time will take time to change. We appear to be at the outset of such a change. There are a few alternative themes and assets likely to prosper under the changed conditions. In bonds, short-maturity bonds will do better. In stocks, active investing and value investing will likely gain relevance (again).
As an active and value investor, I recognise that the above presumptions might be the result of bias or wishful thinking – interpreting information in a favourable rather than an objective way. Nevertheless, the arguments about interest rate cycles and their influence on stock performance are well supported by historical data and logical reasoning. Capital always flows towards assets, strategies, and themes that promise better risk-adjusted returns. The risk premium that stocks have enjoyed for a long time has narrowed significantly as interest rates have normalised in recent years. Bonds appear to offer better risk-adjusted return prospects than general stocks today.
However, with inflation risk persisting, the upside prospects for interest rates remain alive and active. This introduces uncertainty about the prospects of long-term bonds, whose prices are more sensitive to changes in interest rates (bond prices decline as interest rates increase). Meanwhile, short-duration bonds, those with a maturity of less than two years, are better placed in this respect. Most stocks will underperform going forward. So, the skill of identifying the few likely to outperform (active investing) will definitely be an advantage. As valuation becomes the decisive factor behind investment decisions, value stocks long shunned will again have their time in the limelight.
Subscribe
Subscribe to receive our latest content in your Inbox.
AMN CAPITAL 