At The Motley Fool, we pick individual stocks, so there's no question we have skin in the game on this question. But it's an important one, so in this segment of the MarketFoolery podcast, host Mac Greer, Motley Fool Director of Small-Cap Strategy Bill Mann, and Matt Argersinger of Million Dollar Portfolio do their best to give some unbiased opinions on Robert Shiller's idea that an excessive amount of passive investment is damaging the foundation of the stock market.
A full transcript follows the video.
This video was recorded on Nov. 14, 2017.
Mac Greer: Guys, let's close by talking about the oh-so-sexy world of passive investing and indexing. One of my favorite economists -- if you can have favorite economists --
Bill Mann: It is kind of a geeky opener. [laughs]
Greer: I know. But we've interviewed him, I really love Robert Shiller.
Mann: He's a great interview, isn't he?
Greer: He is. And he's won a Nobel Prize. We should probably mention that. On CNBC yesterday, guys, he had some ominous or cautionary things to say about passive investing and indexing. To put it all in perspective here, in 2016, investors invested more than $0.5 trillion in passive funds.
Mann: That's kind of a lot.
Greer: It's a big number. Here's what Robert Schaller has to say. He says, "The strength of this country was built on people who watched individual companies. They had opinions about them. All this talk of indexes, it's a little bit diluting of our intellect. It's become more of the game." Bill Mann. Indexing, bad for the market? What do you think?
Mann: It's a tragedy of the commons. And it's a little disingenuous for us -- we're stock guys. "Yes, passive investing is bad!" [laughs] But it does expose certain risks that you don't otherwise have, and I think people need to know about them. The market is a price discovery instrument. If everyone is going to passively invest, nobody is doing the research by which discovery happens. And I think about the fact that, we were just talking about Buffalo Wild Wings potentially going private. It's been a pain for them to be public the last couple of years. It can't be a good environment in which passive investing is such a huge thing, to think about going public as a company. Why would you? You'd have to hope to end up in some index constituency. You might not be there. So, it's expensive, and it's a hassle, and nobody's watching.
Matt Argersinger: I agree. What it does is, it eliminates the distinction between quality companies and companies of lesser quality. As Bill said, you could be a bad company, but if you're lucky enough to be in part of this Dividend Aristocrat index, money is flowing your way and your stock price is probably high as a result, whereas a company that's not in that index that might be performing better, might be an interesting opportunity, it's not getting that "love" from the market. So, I agree. I think the discovery aspect of, not just the price discovery, but distinguishing between companies that should be valuable, or more valuable or less valuable, it's become harder when money is flowing blindly into the market with these indexes. And some indexes are very specifically targeting what kind of asset classes they target. And whether or not your stock is in one of those targeting areas determines what kind of value it's going to get in the market. It's kind of a strange place to be.
Greer: So, it sounds like it's a bit of a paradox, that indexing is more effective as long as you have a critical mass of stock pickers.
Mann: I think that's well put. You have to, you have to have people, at the end of the day, doing some analysis to set the price. And I think they are very interesting areas. Do you know how long it's been since the S&P 500 has had more than a 5% drawdown? Not in a day, just from its peak. 5%.
Argersinger: Early 2016?
Mann: Yeah, it's been a while. It's been more than a year. In the same year in which $0.5 trillion have gone to passive investing, and a lot of that goes into index funds that are tracking the S&P 500. So, I think there's something meaningful going on. And when it breaks, and it always does break, it will break in a way that might be very, very uncomfortable for people.
Greer: And on that happy, upbeat note ... [laughs]
Mann: The Undertaker is back! But, we do still think index investing is a great vehicle for people. But I don't think it's something that is without risk. And I think that's what Shiller is saying, too.
Argersinger: Right. And what I said earlier, too, companies that aren't in those indexes can also become values. They become opportunities for us because they're misvalued because they're not part of those indexes. So, it also creates opportunities as well. And when everything starts selling off at some point, which it will, inevitably, everything is going to be selling off, because so many people own these funds. And, again, more opportunities for the active investors.
Greer: So, you need your active investors, and you need your indexing. Without one, the other doesn't work as well.
Mann: Yeah. It's funny, when I was a fund manager, we were managing funds in a lot of emerging markets. And in some countries, like in Egypt, for example, the index fund makes up about 50% of the trading volume every single day for the stocks. And it's a situation that will break. And, at some point, you're going to have the same situation here. I don't know what the percentage is here. Obviously, it's a much more dynamic market than Egypt, it's a broader market. But, at some certain percentage, you're no longer tracking, you are pushing.
Greer: 50% of the market in Egypt?
Mann: Yeah.
Greer: There you go. So, if you want to win a bar bet and you're listening to the podcast right now, there you go. I would have had no idea. Impress your friends.
Mann: [laughs] Here's your random fact.
Greer: [laughs] You're going to be the life of the party. Or not!
