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Why your love of index funds is terrible for the economy

Index funds cause irrational stock-market meltups and meltdowns, and recommends 4 fund-management stocks that are cheap.

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Michael Brush says index funds cause irrational stock-market meltups and meltdowns, and recommends 4 fund-management stocks that are cheap.

By Michael Brush, MarketWatch

Vanguard’s John Bogle didn’t know it at the time, but when he created the first index fund in 1975 he unleashed a monster.

Stock index funds have grown so popular that they now command $4.6 trillion in assets. That might seem like a good thing. After all, index funds have “democratized” investing and simplified the process for the average person.

But the truth is that index funds have gotten so big that they now pose a major risk to our economy — and even to capitalism itself. Here are three reasons why.


Index funds contribute to market melt-ups and meltdowns

The popularity of indexing has increased the risk of irrational bull runs and sharp declines.

On the upside, there are fewer active managers to “sell at the top” and keep runaway bull markets from getting irrational. That sets up markets for eventual big selloffs.

Here’s the other risk to the downside. With so much money in index funds (Bogle puts it at 17% of U.S. stock-market value), active managers now have far less cash on hand to buy stocks during sharp declines. This has blunted a natural shock absorber in the market.

A big part of the problem is that big index funds like the ones representing the S&P 500 (SPX) and the Dow Jones Industrial Average (DJIA) are bunched up in the same names. So once selling gets going, individual investors panic and ramp up selling, pushing the same stocks down even more. “Selling begets selling and that’s when you get a run on the market for 800 points in a day,” says Neil Hennessy, chief investment officer at Hennessy Funds, referring to one particularly gut wrenching intraday move in the Dow in December.

This kind of volatility makes it harder for companies to raise capital, which hurts economic growth. I’m sure Lyft is not happy it has to raise capital in this market — because it is going to bring in much less.


Index funds reduce the quality of stock analysis

Harvard Law School professor John Coates likes to say that index funds create “social benefits” in the form of lower expenses. That’s true, but it is only captures a piece of the picture.

Because even when active managers underperform as they charge higher fees than index funds, they are still adding lots of value in our economic system. By deploying legions of brainy analysts to drill down on companies, active managers help ensure that stocks are priced correctly.

This is key in our system of capitalism because it assures that investment money flows to the companies that will make the best use of it. In other words, when securities are priced “correctly,” money raised via stock issuance is more likely to go to innovative and efficient companies like Amazon.com (AMZN) and less likely to go to sham managements. The trained professionals working for active managers identify the Amazons of the world and drive their stocks higher. Likewise, they root out the sham managers and drive their stocks down so low it makes it tough for the scammers to raise capital.

This matters because while the stock market is many things to many people — from retirement planning tool to day-trading playpen — at its core the market’s purpose is to allocate capital to the best companies.

Of course, we know that active managers and their armies of analysts don’t always get it right. But without their work, securities are much more likely to be mispriced. That’s because active managers are better at valuation analysis than the mom and pop investors in index funds. By definition, these passive investors have collectively thrown up their hands and said they can’t or don’t want to do securities analysis.


Index funds contribute to poor corporate governance

Index funds now own so much stock, shareholder voting power is getting concentrated in the hands of the major players in this space, like Vanguard, BlackRock (BLK) and State Street (STT) It would be better to have more diversity among the people casting shareholder votes on key issues like who gets to be on boards or whether companies disclose political campaign contributions.

Bogle worries about this problem. In a recent Wall Street Journal opinion piece, he cautioned that if the popularity of index funds continue to grow, voting control over U.S. companies will be too concentrated.


The investing angle

Wherever there’s a big trend there’s normally a good investing angle somewhere, and that’s the case here.

One angle is to own the shares of big players in the indexing space like BlackRock. After all, indexing is not going away even if it creates problems. And market-related companies like BlackRock are falling a lot more than the market, which is typical during corrections. It makes sense to buy market-oriented companies as a contrarian play.

Plus in the weakness, the right kinds of insider buyers have popped up at BlackRock, which is also a player in active fund management. So I just reiterated this name as a buy in my stock newsletter Brush Up on Stocks. I first suggested this name in July 2010, in part because the right kinds of insiders were buying. The stock more than tripled by the start of 2018, nicely outperforming the market.


The ultra-contrarian angle

Here is an even more contrarian way to go: Buy the shares of investment companies that offer active management. They are getting hit by a double whammy. They’re suffering from big outflows as investors flock to indexing. And as stock market-related business, they’re getting slammed by the correction. On average, asset managers are down about 35% from recent highs, says Hennessy.

They look attractive for several reasons. They are cheap. Hennessy Advisors (HNNA) trades at a minuscule trailing price-earnings ratio of just four. T. Rowe Price (TROW) sells at 12 times earnings. Franklin Resources (BEN) goes for a P/E of around 10.

These stocks are actually cheaper than they appear because asset managers normally have huge cash positions, points out value investor Ian Lapey, who manages the Gabelli Global Financial Services Fund (GFSIX)

Franklin Resources, one of Lapey’s top 10 positions, has around $15 a share in cash, and its stock recently went for around $32. In other words, about 45% of the market cap is cash. Another one with around 45% of its market cap backed by cash is Diamond Hill Investment Group (DHIL) which has a P/E of just under 10. This is another top 10 holding at Lapey’s fund. The big cash positions at Franklin and Diamond Hill significantly limit the downside in these shares, believes Lapey. He also likes these names because insiders own lots of company stock.

The discounts in these stocks seem like a disconnect because asset managers have solid margins and great cash flow. “Even in tough times they are extremely profitable,” says Lapey. That means they can return cash to shareholders via dividends and buybacks. The discounts also make asset managers potential acquisition targets.

If you don’t like owning individual stocks, consider owning Lapey’s fund, which launched Oct. 1, as a play on active managers. He owns two as concentrated bets among his top 10 holdings, and Lapey had a good record while managing the Third Avenue Value Fund (TAVFX) During the roughly five years he was co-manager and lead manager of that fund, it gained about 12% a year, after fees.


A surprise catalyst

“Investors are extrapolating that these companies will continue to struggle with outflows,” says Lapey. But if somehow their investment results improve relative to indexes, they may reverse the investor exodus. Then the shares of asset managers would climb back toward their much higher historical multiples.

That could be the next chapter in this story — if we are now in a sideways or persistently sluggish stock market. In this kind of market, active managers tend to post better returns relative to indexes. Meanwhile, they still have the same solid brands, stables of talent, low fixed costs, and important distribution and marketing networks that always had. So they should see a big payoff if relative performance improves.

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Finance Magazine: Why your love of index funds is terrible for the economy
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