Passive Indexing and its Looming Pitfalls.

In today’s post, I’ll talk about passive indexing. The investor class has long fancied its decision-making skills. Its ability to perceive and manage risk. On decisions bolstered by probability and statistics. Rather than the whim of cognitive psychology.

Of course, the “overconfidence effect” has long plagued investors. This simple bias dictates that a person’s subjective confidence in his own judgements is reliably greater than the objective accuracy of such judgements. Especially when confidence runs high. As overconfidence is a perfect example of the miscalibration of subjective probabilities.

Investors — like all humans — base many of their decisions not upon the subjective analysis of statistics and probability, but on simple “rules of thumb.” Cognitive shortcuts, known as “heuristics” that simplify the decision-making process. And leave us feeling good in the wake of those decisions.

Following nine years of stellar equity returns, we’ve lately noticed that many investors are allowing these heuristics to drive investment decisions. Even as some of the decisions being made, upon closer scrutiny, may prove dangerous.

Consider the act of investing in passive indexes. Since 2009, investors have grown to favor passive index funds over their actively managed counterparts (mutual funds, money managers, etc.). Even such esteemed areas of the actively managed investment marketplace as global macro hedge funds fell out of favor as the S&P 500 rose like a phoenix from its 2009 low. Which makes sense. When the S&P 500 sat at 667, an investor needed only to buy the passive index. Then watch as stocks retraced their paths to previous highs. Eventually breaking out to new, all-time highs. Which the S&P 500 did in mid-2013, following a fourteen-year period of sideways consolidation beginning in 2000.

It was so easy! Buy the index. Sit back and watch as it moonshot to new highs with a minimum of volatility.

Investors slurped up passive indexing like winos do Ripple. Relishing the inexpensive, diversified means of owning a broader market. As undervalued as stocks were, they had nowhere to go but higher. Causing investors big and small to vacate actively traded money management strategies in favor of passive indexes. They were easy. Cheap. And effective.

Today, the ten largest indexing firms custody $9.2 trillion in assets. Representing a third of the value of the S&P 500’s tradeable shares. Moreover, the massive inflows continue today. The SPDR S&P 500 Exchange Traded Fund (ETF), or SPY, currently holds over $275 billion. Being market-cap weighted, it is engineered to mirror the weightings of the S&P 500 index. Capital comes in, and those running the index quickly allocate that capital to shares across the S&P 500 according to each company’s representative weighting.

Investors get to own the index, diversified among 500 companies, at an average annual expense ratio of only nine basis points. So easy a caveman could do it!

Theodore Roosevelt said that “nothing in the world is worth having or worth doing unless it means effort.”

And therein lies the problem. Passive indexes haven’t simplified the world of investing. They simply made investing easy when it should have been easy. Hell, in 2009, you could have purchased ten stocks, watched them rocket higher and saved the nine basis points expense.

Today, some of the flaws inherent to passive indexes have become increasingly apparent.

Take the Coca-Cola Company, the 27th largest in the S&P 500. Currently represents roughly one percent of the index. Meaning, every $100 invested in the SPY index reallocates $1 to the shares of Coca-Cola. Easy enough, right?

Closer scrutiny reveals that Coca-Cola shares have returned an average annualized 4.5 percent to investors the last five years. Simultaneously, the SPY has returned nearly 14 percent annualized. Obviously, Coca-Cola has underperformed the index. But, it’s still made money.

Problem is Coca-Cola has seen both sales and net operating income fall for five straight years. Which makes sense. Because in this increasingly health-conscientious society, selling carbonated sugar water has become less profitable. Yet shares have not fallen. And the company’s market capitalization has grown larger. Due to the massive and consistent capital infusions Coca-Cola’s shares receive via indexes like SPY.

Coca-Cola’s P/E ratio, at 24.50, tells the tale. This company, with its declining sales and falling net income, remains 20 percent pricier than the S&P 500 index.

That’s as odd as Pete Rose in a Phillies uniform. Yet such distortions are becoming commonplace with the rising popularity of passive indexing.

Consider last month’s 10-percent correction. Typically, a pullback triggered by increased volatility would have been milder than the one-week, ten-percent cratering we experienced. Yet it turned into a panic-inducing decline because of another of Wall Street’s Frankenstein monsters.

Thanks to Wall Street’s sheer greed, a new breed of indexes enables less-than-savvy investors to bet on volatility. But instead of being safe, these bets ended up exploding in investors’ faces. The VelocityShares Daily Inverse VIX Short-Term ETN (XIV) was engineered to short the VIX. Last month, it lost 85 percent of its value overnight. It was liquidated soon after. Investors lost everything. Moreover, two of the largest such ETFs had amassed $4 billion in assets. Turning a garden-variety pullback into a 2,000-point meltdown due to systematic selling and the ensuing panic.

It gets worse.

The most popular passive indexes are constructed according to the “float,” which represents the number of shares available to the investor public minus those held by company insiders. Translation? Insider holdings, or the number of shares owned by a company’s leadership team, do not figure into the construction of the indexes. Even though the number of shares owned by insiders has long been one of the most effective success indicators for stock performance. Meaning these indexes invest equally in the shares of companies detested by their own leadership teams as they do in those whose executives can’t get enough of the shares. Ranking as nonsensical and non-investor friendly.

This isn’t to denigrate all passive investing. Our investment team utilizes passive indexing as a component within client’s portfolios. But, following the markets historic rise, we believe the the low-hanging fruit has been picked. The easy passive gains have been had. The cycle has turned to one that will favor active investors. Stock pickers. Leading us to reallocate capital from index allocations to more promising, attractively valued equity positions.

Today, investors can find much greater value in the individual shares of companies not held in the largest indexes. Or in companies held within the index that can, in fact, boast of substantial insider ownership.

Point is, passive indexing does not always represent a simple way to invest. Not if you believe simplicity should be accompanied by success. Remember the 2010 Flash Crash? Such issues have become evident during one of the market’s great historical run-ups. How will such investments perform now that volatility has returned? Now that markets are not longer setting new highs every month? What other adverse, quirky features might punish unsuspecting investors?

Still, people will continue to blindly invest in passive indexes. Because it’s easy. Involves no effort. And the financial media loves it. Always mentioning how the iconic Warren Buffett believes the average investor should buy the index and then turn his attention elsewhere. Though Mr. Buffett would never do so himself.

Psychologists talk about the “recency effect.” Whereby we tend to view something that has recently been effective, and then overestimate the continuing probability of success. Another heuristic upon which we rely. As its so much easier than attempting to discern patterns of success. Especially those that have worked in all environments and time frames. Worse, we tend to underestimate the likelihood of low-probability events. Like stock-market crashes.

Such findings form the basis of the collaborative field of psychology known as behavioral economics.

Nobel Prize winning economist Daniel Kahneman and his colleague Amos Tservsky spent decades illustrating the various means by which humans exhibit nearly two dozen errors in reasoning. Bad decisions lead to bad outcomes. Kahneman and Tversky showed that we usually don’t even realize we’re committing such errors.

Remember in 1999 when all one had to do was buy whatever.com stock to make a fortune? Remember how that turned out?

Likewise, Kahneman and Tversky proved that our psychological dispositions often stand in the way of good decision making. Even though economic theory often assumes that we make economically beneficial decisions, always maximizing utility, acting pragmatically, reality reveals otherwise.

The question is not if we’ll fall prey to cognitive errors. But by which of them we’ll we be victimized. And how severely. How often will investors view their current practices, limited amounts of information and a bit of early success, and then conflate the probability of those same practices leading to continued and ongoing success? Behavioral economics reveals that the answer is often.

Mental shortcuts, or heuristics, are very useful for busy people seeking to make regular, quick and effective decisions. Yet, sometimes we drastically overestimate the success of using such shortcuts. And the results can be, on occasion, devastating.

For example, how many people believed after the early 2000 correction in tech stocks that shares would recover and rise ever higher? Nearly everyone. And two-and-a-half years later, after the S&P 500 had lost nearly 54 percent of its value, they realized how wrong those assumptions had been.

The great Stephen Hawking once said that “Intelligence is the ability to adapt to change.”

Well, markets have changed. The easy returns have been had. Now we’ll have to work for them.

The dictates of behavioral economics provide a cautionary tale as to what is transpiring in today’s passively driven equity markets. Nine years into a bull market. So much closer to the end than the beginning. Can investors continue to eschew introspection and analysis? Doing the same thing and expecting the same outcome?

Historical evidence shows that Mr. Market will have the last laugh.