Blind Capital

According to Morningstar, the average US equity manager, has underperformed the S&P 500 Index over the past one, three and five years. Given investors natural tendency to chase what’s working, and ditch what’s not, “the death of active management” is becoming a popular consensus sentiment.

Before writing off active management and jumping on the index fund bandwagon, investors would be well served to pause and reflect.  Might this be a cyclical phenomenon?  If so, when have we seen this in the past?  And most importantly, how did it play out last time?  Spoiler alert: yes, this is cyclical; yes, we have seen this in the past; no, it didn’t turn out so hot for overvalued indices overweighted in overvalued large caps.

Ed Chancellor’s Capital Account provides some historical perspective (pair with the more recent Capital Returns, and you have the two best finance books I’ve read this year).  For memory-challenged-investors, the book offers a wonderful review of the decade leading up to the tech bubble, via a collection of essays from Marathon Asset Management.

Here are a few excerpts for all you closet indexers out there:

The periods over the last few years when the indices have outperformed active managers have largely been due to distortions created by the indices themselves, rather than to the alleged superiority of index investments. In fact, the combination of blind capital and arguably flawed index construction is to a great extent responsible for the current problems of the bear market.

By facilitating the TMT bubble and other recent bubbles, indexation has also led to a gross misallocation of resources across economies. Passive investing, in our view, is dumb investing. Shares are bought as companies increase their weighting in the index and are sold when the weighting is reduced.

The consolidation of the asset management industry has exacerbated the problems caused by indexation. This has produced a proliferation of large investment firms, commonly managing more than $100 billion in funds. Since they are obliged more or less to own shares relative to their size in the index, these firms have become indistinguishable from passive investors. During the later stages of the bull market, the growth of passive funds and closet-tracking fund management firms . . . created an artificially high demand for certain stocks relative to their supply. As a result, these funds benefited from the bubble they created in certain stocks.

A direct consequence of these distortions was the growing obsession of fund managers and the clients with tracking error. As it became more difficult to beat distorted indices, active managers decided not to take too much active risk relative to the benchmark. With more and more money invested in this way, a Ponzi scheme developed. This led to the ultimate disaster for passive investors. In the twelve months after March 2000, the largest, supposedly least risk, and widely owned shares collapsed relative to the market. The ten largest companies, which then accounted for some 27% of the index, underperformed the market by a staggering 23.5%.

Once passive investing starts to distort the pricing mechanism, the ultimate result is the underperformance of the original beneficiaries of that distortion. The future performance of any investment practice is significantly altered once it has been widely imitated. This is what happened to index investing. 

A common question put to professional investors during the bubble was, “why do I need an active manager when the index can be bought for a nickel?” Some three years later, the answer is clear.


We are once again, beginning to hear that question today. And once again, we think the answer will be clear “some years” later.

Passive investors typically look brilliant in the late stages of a bull market. They are looking awfully smart today, particularly relative to more disciplined investors who are inclined to avoid the overvalued businesses driving most of the market’s gains.

The proliferation of index funds drove the 90’s tech bubble and ultimately, it’s collapse. If you thought that was painful, wait until you get a glimpse of the hangover around the corner from the Blind Capital piling into ETFs.


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