Central Bank “Distortion” Is a Red Herring

The rise of passive investing is upon us.  Years of substandard performance from active fund managers promising to be experts able to beat the market consistently has led to a meaningful shift toward lower-cost investing.

Figure 1 – The percentage of actively managed large-cap U.S. stock funds that beat the S&P 500 on average rolling five-year periods.
Figure 2  – Net monthly flows to active and passive funds in 2016.
Active fund managers have continuously attempted to push back against this trend by claiming that the unprecedented efforts of central banks in response to the 2008 crisis are temporarily “distorting” financial markets and making it tougher for active fund managers to add value over passive investment strategies in recent years (despite the fact that Figure 1 shows they haven’t just failed in the post-crisis era).  Unfortunately for the active management industry, the evidence in support of their argument, like their excess return, is conveniently missing.

Across developed markets, central banks are tasked with maintaining steady price growth (and sometimes full employment and financial stability).  Presumably, if central banks had overstepped their mandates in an attempt to provide excessively-accommodative policy, such a distortion would be evident in inflation readings.  Using the U.S. and the Federal Reserve as a representative example, there is no such evidence that that is the case:

Figure 3 – Year-over-year core PCE inflation—the Fed’s preferred inflation gauge.
Secondly, active managers often complain that the Fed is artificially suppressing volatility, something from which active managers and hedge funds often try to profit.  However, there is little evidence that volatility is below historical norms:

Figure 4 – CBOE Volatility Index vs year-over-year nominal GDP growth

The above evidence demonstrates that, fundamentally, the Federal Reserve pushing interest rates to zero is not any different—from an accommodation perspective—than when it cut rates in previous crises.  Despite the fact that nominal rates have been pushed lower than in the aftermath of previous crises, there is no evidence that this time they were more accommodative.  However, the one effect of a lower absolute level of rates is its impact on the discounting of future events.  As interest rates have fallen to basically zero, events further into the future are reflected more strongly in current asset prices.  Thus, in theory, the low absolute level of rates (ignoring its stimulative effects) should actually increase volatility, not suppress it.  This also means active fund managers must focus more on the long-term and macroeconomic conditions, things notoriously difficult to predict beyond a couple years and something at which most active fund managers have continually failed.

On a related note, many active managers will point to the popular “price-earnings (PE) ratio”—the ratio of a stock’s price to its earnings per share.  Active fund managers have claimed the S&P 500’s historically-elevated PE level is a sign that stocks are overvalued and not reflecting individual company “fundamentals.”  However, the PE ratio is not adjusted for changes in discount rates.  Ignoring the tech boom and Great Recession, the PE ratio has risen steadily since the 1980s, reciprocating the downward march in interest rates since then.

Figure 5 – S&P 500 Price-Earnings Ratio (via macrotrend)
Figure 6 – Interest rates have steadily declined since the 1980s.
A more effective way of measuring general stock market valuation that accounts for changes in discount rates would be to look at the equity risk premium: the excess rate of return implied by purchasing stocks as opposed to safe government Treasurys.  By this measure, it appears stocks are actually UNDERvalued relative to their history:

Figure 7 – Equity risk premia in the developed world, 1990 – 2016.
There certainly is value in active managers that help reinforce efficiently-priced assets/markets and provide trading liquidity.  However, given their clear lack of evidence of their ability to match or outperform passive investment, it is increasingly hard to justify active management making up 70% of the asset management world.  The shift of savings from active to passive funds should continue for some time, boosting savers’ returns and reducing the inefficient overfinancialization of the U.S. economy (and other developed countries).


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