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Are Investors Headed For a Buffalo Jump?

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Are Investors Headed For a Buffalo Jump?

Alright, your first thought is probably “What in the world is a Buffalo Jump?”
 

You aren’t alone. Unless you are a fan of Native American history, or have traveled through Montana, a Buffalo Jump is not something you hear about every day. However, the Buffalo Jump played an important role in American history and the near extinction of the Plains Bison.

The Buffalo Jump was a cliff that Native Americans used to hunt and kill bison. Herds of bison were enticed – by being spooked – to begin stampeding toward the cliff. The Native Americans used numerous tricks and deception to funnel the bison into a tighter formation to increase the number killed and to eliminate the herd’s ability to turn in a different direction. At the point where the bison were running at full speed and tightly packed together, unable to see ahead of them, they would plunge off the cliff to their death. A gruesome, yet very effective, hunting technique that was necessary for survival of Native Americans in the plains.

What does a Buffalo Jump have to do with wealth?
 

I’m glad you asked. The current market environment – with the majority of money flowing into passive index funds and especially ETFs – makes me think of a Buffalo Jump. In 2016 inflows into all passive funds (including ETFs) were $516 billion, while all active funds saw outflows of $326 billion. For the 12 months ended June 2017, passive funds took in 68% of all net new sales into mutual funds, while active funds took in only 32% of the net new sales. This trend began in 2011 and has been growing in proportion ever since. Hmm..looks like a herd of investors might have formed and may already be stampeding.

Wait, wait, wait, many advisors and pundits are saying that, “This time it’s different.” (That phrase seems to pop up at the most unfortunate times for investors). They argue that active investing, especially in the more efficient markets, is dead and that the most appropriate way to invest in those markets is through the lowest cost index funds and ETFs. If you still aren’t convinced, they will simply show you the investment results of said funds and ETFs to prove it. Depending on the organization pulling together the numbers and the time period being viewed, passive index funds and ETFs have outperformed active funds by a wide margin for the past several years.

Related: To Robo or Not to Robo Is NOT the Question in 2018

What these advisors and pundits fail to mention is that when the investor stampede is running at full speed the outperformance of index funds becomes a self-fulfilling prophecy. Look at the stocks that are leading the U.S. stock market higher so far in 2017 – Facebook, Apple, Amazon, Alphabet, and Microsoft. What do all of these stocks have in common? Yes, they are all technology companies. But, they are also the largest stocks in the U.S. market and in both the S&P 500 and NASDAQ 100 indexes. Based on simple math, as more money piles into passive funds and ETFs of those two indexes (they happen to be two of the most popular indexes based on fund flows), the largest proportion of this money flows into these few stocks. In fact, for every $1 going into a NASDAQ 100 index fund or ETF, 42¢ goes to the five stocks listed above! Those significant flows push the prices of those stocks higher, which pushes the return of the index higher, which is used to “prove” that active investing in U.S. stocks is dead, which fuels more money going into passive index funds and ETFs, which..I think you get the picture.

Back to the Buffalo Jump. Investors seem to be in near full stampede mode currently with the majority of new investment flows going into passive index funds and ETFs. Many advisors and pundits, playing the role of Native Americans, are using deceptive arguments to continue funneling investors and their money into the same products and convincing them not to turn in the direction of active investing. In some cases these individuals are adding ever more exotic investments to portfolios of index funds in the name of diversification. As I addressed in a previous post, this added complexity can easily go too far and does not always lead to better results for investors.

Be wary of the stampede as enticing as it may seem. Our stock markets, and entire capital markets structure, was built on the back of active investment management – the proper and proportional allocation of investment capital to those companies with viable businesses, products, and services. It was not built on the blind throwing of investment dollars at baskets of companies simply because they are large or have the best returns over a period of time.

The question now is, “Where’s the cliff?” No one knows the answer to that question. But when it comes the carnage to investor wealth will be similarly as gruesome as the actual buffalo carnage in American history.

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