Seth Klarman on Passive Investing

He is not a fan of the strategy

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Dec 13, 2017
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Index investing has gained in popularity in recent years. As asset managers like Vanguard lower the cost of their products to levels that shame the active management industry, investors have rushed in seeking better returns and lower costs.

Even Warren Buffett (Trades, Portfolio), the "Oracle of Omaha," who has made a fortune investing actively, has advocated the use of passive funds for investors who are looking for steady returns with minimal effort.

Seth Klarman (Trades, Portfolio), who, along with Buffett, is one of the greatest value investors of all time, is not so keen on the idea of passive investing. Earlier this year, Klarman shared his thoughts on the subject in a letter to investors:

"One of the perverse effects of increased indexing and ETF activity is that it will tend to 'lock in' today's relative valuations between securities.

When money flows into an index fund or index-related ETF, the manager generally buys into the securities in an index in proportion to their current market capitalization (often to the capitalization of only their public float, which interestingly adds a layer of distortion, disfavoring companies with large insider, strategic, or state ownership).

Thus today's high-multiple companies are likely to also be tomorrow's, regardless of merit, with less capital in the hands of active managers to potentially correct any mispricings."

This is not the first time Klarman warned of the dangers passive products such as echange-traded funds pose to investors, particularly concerning valuations. He issued a more in-depth statement on the subject in an interview with the Financial Analysts Journal in 2010, titled "Opportunities for Patient Investors":

“I still think indexing is a horrendous idea for a number of reasons. That said, the average person who spends a very small amount of time on investing doesn’t have a lot of good choices out there.

A tremendous disservice is perpetrated by the idea that stocks are for the long run, because you have to make sure you are around for the long run, that when you have unexpected pain, as many people did in 2008, you don’t get out and you actually are a buyer. The prevailing view has been that the market will earn a high rate of return if the holding period is long enough, but the entry point is what really matters.

Stocks trade up when they are put in an index. So, index buyers are overpaying just because a stock is included in an index. I am much more inclined to buy a stock that has been kicked out of an index because then it may have value characteristics—it has underperformed. A stock is kicked out of an index because its market cap has shrunk below the top 500 or the top 1,000.

We all know that the evidence shows that when you enter at a low price, you will have good returns, and when you enter at a high valuation, you will have poor returns. That is why we have had 10–12 years of zero returns in the market. And given the recent run-up, I am worried that we will have another 10 years of, if not zero, at least very low returns from today’s valuations. The mentality of “I’ll save transaction costs and management fees by indexing” ignores the fact that the underlying still needs to produce for you. Indexing usually refers to equities, but the attractive asset class a year ago, on a risk-adjusted basis, was clearly debt, not equity.”

Looking at these comments, it is clear Klarman believes indexing is suitable for some investors, but his fundamental issue is with valuations. Unlike active investing, passive investors have no say over when they buy individual stocks (if buying an index).

For the past 10 years, this has not been much of an issue as the market has only gone up. All you needed was low fees and an excellent tracker to make sizable returns -- returns few active managers could match. But what happens when volatility returns and the S&P 500 starts to move sideways or even falls? It is an interesting question and one we do not have an answer to just yet. Only time will tell.