Over the past couple of years Tracey and I have increasingly spent weekends away walking in parts of the country less inhabited by coach parties and quality transport links. This often means travelling along narrow lanes. You know the ones. Where grass grows up the middle and the potholes are small caves. Our latest expedition was last week in the Black Mountains on the Welsh Borders. The roads are awful, but at least the road closure signs are bilingual.
As a result of this change of lifestyle, we decided an Audi TT was no longer appropriate. Nice styling, but bone-shaking suspension. So we are buying a mid-range SUV. Cue me reviewing consumer magazines, drawing up a short list, test driving them, watching online videos by (quite entertaining) car critics and fretting over the final decision for days if not weeks. I finally decided on a German one – it’s not perfect, but you always make the compromises you can live with. I placed an order and immediately worried that I had made the wrong choice. I will find out come September.
Now can you imagine if I just posted on social media that I had a certain sum of money to invest in a car and decided to buy the first one that came up on Google Search? You would probably think either I had too much money or knew nothing about cars. You certainly would think I had taken leave of my senses. I would call that a passive decision about investing my hard-earned cash.
Passive investors buy high and sell low
Seems incredible right, but increasingly this is how long-term investors appear to be investing their savings. By creating a portfolio invested in multiple passive funds, they are allocating their personal wealth extremely widely without any consideration of quality.
It’s hard to imagine anyone doing this when making any other decision, financial or non-financial. Yet, when it comes to their lifetime savings, they’re happy to do so as the industry has encouraged them to focus on cheap costs.
Now, the industry does have a case to answer here. Many financial products have been too expensive in the past while delivering dubious quality and poor outcomes. Costs were often hidden so it was hard for consumers to make an informed choice. I would argue current levels of transparency, in the main, have meant this is less likely to be the case today.
So why did flows into passive funds continue to rise in 2024 and the start of this year? Clearly there are multiple factors at play, but I think the momentum behind the AI industry was also a factor. Last year you needed to be invested in an AI basket and nothing else. In fact, it was the same story in 2023, too. Diversification did not work. Just own the expensive stocks in each sector and keep buying. Some of the valuations became eye-wateringly expensive, but business fundamentals did not matter. Attention is solely focused on management fees, not what is actually held. In the old days you used to care most about what you owned, whereas today you are more interested in the wrapper.
The momentum in these red-hot AI stocks, fuelled by growing investor flows into passive ETFs and trend-following strategies (again, which are blind to fundamentals) meant old-fashioned qualitative analysis was redundant.
It’s worth remembering how passive funds react to flows: when flows are positive they have to buy and keep buying until the cash is spent. They also have to buy every company in the index – or the most liquid in passive funds that have liquidity thresholds for entry, which creates its own distortions in the market – irrespective of quality of the business model or management. For fixed income it’s arguably even worse because passive funds end up buying the debt of the most indebted companies. Those that issue a lot of debt make their bonds more liquid and easier to trade, so there’s an incentive to issue more and more. As they become a larger share of the index, passive investors must buy it on autopilot.
As prices for both stocks and bonds rise during the day they must keep buying if flows are positive. The same is true in reverse. When flows are negative, passives must sell everything in the portfolio irrespective of market liquidity. They need to keep dropping the price until they find buyers.
In summary, they buy high and sell low. But this gets forgotten when we experience strong, momentum-driven bull markets. Everyone talks about the low costs, not about the execution risks and the unintended consequence of rewarding many poor companies by supporting their share price and probably rewarding their executives irrespective of performance.
The wave of AI momentum is breaking
Meanwhile, when it comes to engaging with the companies on business strategy, governance and social issues, passive funds often follow a rules-based formula at the corporate level rather than focusing on the best outcomes for the investors in each particular vehicle or mandate.
I am not saying passive vehicles have no place in a portfolio, they can be used as a tool to manage risk and to take short-term tactical positions. We have a position in a small-cap US Russell 2000 ETF at the moment for example. However, I don’t believe that investing randomly over the long term makes sense for investors or society.
What has been helpful for those who firmly believe in active management is the waning of the AI momentum trades of the past two years. Thanks to DeepSeek for that. We did see a second momentum trade try and take off in April following ‘Liberation Day’, (US to Europe or MAGA to MEGA), but this fizzled out once people started thinking rationally again.
Just think about it: you sell the S&P 500 and buy the Euro Stoxx 50 due to tariffs. The impact of tariffs has nothing to do with where a company is listed. It’s clearly much more complicated. Where are its end markets, its supply chain, tax domicile, etc.? The analysis must be taken at the company level, a qualitative judgement. A passive switch from the US to Europe via passive index funds is nonsensical. A sledgehammer to crack a panna cotta.
The volatility caused by US President Donald Trump, DeepSeek or global macroeconomic events reminds us that our clients savings need to be invested with care, not just based on cost. Fortunately, this volatility helps active managers to prove their worth – if they are truly active. There are valuation dislocations everywhere right now, from 30-year Japanese government bonds at yields above 3% (not seen going back to the late 1990s) to potential alarm bells in some pockets of private credit. Government bond yield curves are flattening and steepening rapidly (the difference in yields for shorter-term and longer-term bonds issued by the same nation is fluctuating) as investors try to absorb fast-changing policy and economic data, while currencies have resumed their traditional volatility.
There are opportunities to make excess returns and also to destroy capital as momentum-driven bubbles burst. You are brave to allocate blindly in today’s world.
Time will tell if my qualitative choice of car was wise. I don’t doubt Tracey will be tracking it (pun intended) although I will hope to avoid a Madame Macron type appraisal.
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