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June 28, 2011

Why the Deaf, Dumb, Blind Kid Can't Keep Winning Forever

How could a deaf, dumb and blind kid play a mean pinball? I have always found The Who's 1969 classic frustrating: the poor kid can't see or hear, and yet he is blessed with a compensatory talent for... pinball?  Couldn't they have given Tommy a more believable talent, like, say, truffle-sniffing?  The very strangeness of the song always made me think it must represent something important, but what? Well, after reading a recent newspaper article, I have figured the song's meaning out. Pinball Wizard is about index funds.

The article that enlightened me was touting the benefits of passive investing. It cited a study showing that in 2010, 65 percent of actively-managed large-cap funds were beaten by the S&P 500 Index ETF, commonly known as the "Spyder." Other studies have shown similar results-after expenses, index funds have beaten more than two-thirds of their peer active funds over the previous 10 years. The index fund managers had superior average performance without using their ears to listen to earnings calls, their mouths to ask questions of corporate management or their eyes to read research reports.  Turns out that on Wall Street, the deaf, dumb, blind kid really can play a mean pinball. 

How do you think they do it?  What makes them so good? Unlike Tommy's strange prowess with the silver ball, the theory behind index funds' superior performance is straightforward: they are what economists call "free-riders." Thanks to the legions of analysts grinding through accounting footnotes late into the night, the passive index investors can assume that all available public information is quickly baked into the stock price without their help, and therefore they don't need to burden themselves with complicated things like earnings forecasts and cash flows.

They base their businesses on the concept of market efficiency, which states that the investing pinball will ricochet in such unpredictable ways that playing without even looking is as valid a strategy as trying to predict the ball's path. And that means that passive investors can focus on keeping their operating and transaction costs low. Like the pinball wizard, they ain't got no distractions, don't care about no opening bells, don't see no news a'flashin', don't need to buy or sell.

Investors have bought in. It's been almost 40 years since Burton Malkiel began preaching that index funds were a logical choice in a world of efficient markets, but in the past three years their growth has gone through the roof. According to a Tabb Group study, in 2007, only 21 percent of managed long-only U.S. Equity assets were in passive funds. In just three years, Tabb estimates that this percentage more than doubled, climbing to 44 percent in 2010. 

There are a lot of explanations as to what caused the surge in passive investing. The popularity of ETFs is often cited as one of the prime suspects, and the numbers do somewhat back this notion up, with ETF assets having crossed the trillion dollar mark last year after their 18th consecutive year of market share growth.

Another explanation is that the 2008 credit crisis changed investor psychology. After investors witnessed almost all stocks plummet in unison, they concluded that exposure to stocks in general, or "beta" as professionals call it, is a far more important driver of returns than individual stock picking.  

A third explanation is that the cumulative weight of years of personal finance articles telling you that you're no Warren Buffett has finally sunk in. Or, maybe due to a combination of all of the above, we've finally hit Malcolm Gladwell's tipping point, the point where everyone around you seems to be going passive, so you do it too.

The investigations into expert networks and inside information are likely to add more fuel to the passive fire. As we keep reading about new criminal charges for the sin of learning too much information, investors who study fundamentals will err on the side of safety.  Although there have probably only been a small number of firms using information that crossed the legal line, fundamental investors may choose to avoid going near sources of unique information, making the stock-picking game even tougher, and depressing active returns.  Given the way even an announcement of an investigation can cause an avalanche of redemptions, investors may prefer funds that act more like Tommy would act in a world of 24-hour news: stand like a statue, no change in the routine, don't buy ahead of mergers, always play it clean. 

But while it may be cleaner from an insider trading standpoint, not all regulators are on board with this new deaf-dumb-blind market. In April, the International Monetary Fund released its Global Stability Report, which stated that the "disproportionately large" amount of passive indexing could "pose a risk of disruptions in some markets."  The same month the Financial Stability Board raised a similar concern, saying that the focus on indexing could "create conditions for acute redemption pressures... in situations of market stress."  Global regulators are starting to realize that if markets become dominated by non-seeing, non-thinking players all choosing the same stocks in the same proportions, crashes and disruptions may become more likely.

Can passive indexing realistically ever dominate the market? In theory, no. Passive investing should have a natural cap. It relies on the notion that stocks are efficiently priced at all times, a notion that only makes sense if there are a lot of players painstakingly researching, testing and debating the merits of each stock, and then ultimately putting their money where their mouth is. With enough people working at predicting the future, the wisdom of crowds is achieved. Stock prices will then reveal all known information at all times, which allows passive investing to work.

But with unhindered growth, eventually passive funds would siphon enough capital away from the active side that stock prices would no longer be efficient. Ironically, the passive funds own success would trigger a point where, due to less competition, stock picking would become a much easier game. At that point, active funds as a class will begin to consistently outperform the index funds, and money will begin to flow back the other way. In the long term, some sort of equilibrium between active and passive investing must logically be reached.

As we march towards that long-term outcome, let's raise a glass to the true students of this pinball game-the fundamental investors who can stomach through pages of accounting footnotes, two-hour earnings calls and complicated spreadsheet models that are never quite finished. They have been doing the necessary heavy lifting of the investment world, while suffering the indignity of seeing the passive funds often beat them at this difficult game. But the performance disparity won't last much longer.  Passive index funds have had an amazing run, but due to their own success and the recent surge in their popularity, we may be nearing the time when they surrender the pinball crown. We all know that a deaf, dumb, blind kid can't really play a mean pinball.



Dan Mathisson, a Managing Director and the Head of Electronic Trading at Credit Suisse, is a columnist for Traders Magazine.  The opinions expressed in this column are his own, and do not necessarily represent the opinions of the Credit Suisse Group.

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