Is the passive bubble ready to burst?

Everyone has heard about the bitcoin bubble; Neil Woodford has warned of a new tech bubble; and now investors are voicing concerns about a passives bubble. But if such a bubble exists, is it ready to burst? Or will index funds continue to steal market share away from their active peers?

Is the passive bubble ready to burst?

Well, maybe not a bubble per se, but there seems to be a growing consensus that the passives industry has ballooned to a dangerous, unsustainable level.

Jupiter Merlin sounded a warning about an ETF liquidity crisis last year at around about the same time Bloomberg released data showing that there are now more market indices than there are US stocks.

That last point is “quite a scary thing” that should give investors pause, according to the BMO GAM multi-manager team.

While setting up a segment on passive funds during the group’s outlook roundtable on Wednesday, Scott Spencer, one of the team’s investment managers, said: “We happen to think it [bitcoin] is more in that bubble territory than not, but perhaps it’s not the only bubble.”

"It might be time to bench some of the benchmarks."

Bench the benchmarks

“We have started to worry about the sheer amount of money in passives and reduce our holdings,” Spencer continued. “Volatility has been quite low but if that picks up or maybe we start to see rising rates, rising inflation, we really want to be biased toward active managers. You could argue it might be time to bench some of the benchmarks.”

Matthew Hudson, CEO of asset management consultancy firm, MJ Hudson, has taken a more definitive stance on the existence of a passives “bubble”.

Last November, he proclaimed that “the passive fund industry is near the top of a bubble in terms of returns right now” and called for the bubble to burst by the end of 2018 or early 2019, “especially once interest rates and volatility increase”.

“Passives are always spoken about in terms of costs – understandably, given fees remain a defining factor of the investment industry,” he said at the time.

“However, it will be interesting to see what happens, and where the discussion goes, when passives start to deliver negative returns and the only person on the side of the investor is a machine that is unable to make a decision other than to follow the others – like electronic sheep (think Philip K Dick).”

The BMO GAM multi-manager team are not the only investors who have been “benching the benchmarks”.

Wealth manager Psigma has also cut its passives exposure to just 10 to 12%, sidelining most of its passive funds across its regional allocation with the exception of the UK.

“Passive investments have been a fantastic opportunity to charge low fees and make good money from indices,” says Tom Becket, the firm’s CIO.

“That world has now changed,” he continues. “I think that indices will struggle to make much headwind in the next few years but I think we are going to see the dominance of certain regions or sectors which will once again justify the high fees the wealth management industry and active managers charge.”

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