The steady rise of the major stock indices that the market has enjoyed since The Great Recession is due in large part to the growing popularity of passively-managed index funds with investors and financial advisors. Numerous historical studies show that passive investments almost always outperform their actively-managed rivals during bull markets, so these funds have seen an enormous amount of capital flow into them as a result. But actively-managed funds tend to outperform passive offerings when the market goes down, and some portfolio managers are now predicting that the index fund bubble will soon burst.

An Overpriced Market

John Rogers, lead portfolio manager for the $2 billion Ariel Fund, believes that there is a growing bubble in the market indices, fueled by the constant inflow of money into passive index funds, according to Institutional Investor magazine. As more and more capital pours into these funds, the prices of the stocks in the indices have risen commensurately, and investors who buy in at this point are paying sky-high prices for the stocks in the index. (For more, see: Why ETFs Are Popular with Wealthy Investors.)

Rogers hosted a panel discussion last week in Chicago with three other portfolio managers where they discussed a range of financial topics. He predicted that when the markets eventually drop, the frenzied selling that index funds will have to do will create substantial buying opportunities for active traders and managers. They will be able to pick up quality stocks at a substantial discount from their current prices and can also hold onto those holdings that they feel will rebound quickly. Rogers stated, “Everybody has been buying the same stocks and enjoying the return of the index fund. But when the markets finally turn, people will see all the stocks that they’ve been buying for non fundamental reasons. The next 10 years will be a great period for the stock picker.”

One of the guest portfolio managers at the panel was Robert Bacarella, co-manager of the Monetta Fund and the Monetta Young Investor Fund. He said that he quit fighting the trend towards passive investments 10 years ago when he started the Young Investor Fund, which is managed both passively and actively in equal parts. “An airplane pilot uses autopilot for a good part of the trip; that’s passive investing. The pilot gets involved during turbulence, landing or takeoff; that’s active,” he said. Bacarella went on to say that outperforming the benchmark index often boils down to picking just one or two stocks. It is not necessary to hit a home run every time. A fund only has to beat the benchmark by 1.45% in order to land in the top quartile in its category. (For more, see: A Statistical Look at Passive vs. Active Management.)

Mario Gabelli, another panelist and founder and CEO of $40 billion GAMCO Investors, disagreed with Bacarella’s airplane analogy. He said, “I think of Sully (Chesney Sullenberger, the airplane pilot who landed on the Hudson river in 2009). You don’t worry about the pilot until he has to land on water.”

The Bottom Line

Active portfolio managers may be wise at this point to start accumulating cash that they can use to buy back into the markets if Roger’s prediction is correct and the bubble does indeed burst. The markets have risen steadily over the past seven years, and all economic indicators are now reflecting that we are in the late stage of the rally. Passive investors may be in for a rude surprise when the next downturn hits, while active investors and traders will see many excellent entry points for their buy orders. (For more, see: Is Active Management Making a Comeback?)


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