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BONUS: Index Funds, Robos and Markets

BONUS: Index Funds, Robos and Markets

BONUS Episode!

Matt and I continue our conversation. Listen in to the discussion on

  • Zombie investors: how the massive uptick in index investors may be affecting markets
  • Is it Good? Are the capital markets still good for companies and investors? Have we gotten away from the point of investing?
  • Complexity: If you can’t explain it, don’t invest in it.

Find out more about Mike at https://www.mortonfinancialadvice.com and connect at https://www.linkedin.com/in/mwsmorton/

Transcript

Transcript

Mike: [00:00:00] Welcome to financial planning for entrepreneurs and tech professionals. I’m your host, Mike Morton, charter financial counselor and financial advisor, Matt Robeson. And I riff on an index investing market efficiency and robo-advisors, and more this bonus episode was a discussion following some recordings where we continue the conversation.

Enjoy.

Matt: [00:00:23] So this is Matt Robeson. We’re doing a little bit of a WebEx stra just for big fans of this show. And as soon as we got off the air with our last episode about robo-advisors Mike and I are just started spitballing , of the advantages I have about being a me in this position, talking to an expert like Mike is I get to ask all the dumb questions and sometimes dumb questions lead.

Intelligent places. So Mike, we were just saying, I was wondering what is the aggregate effect of all of these robo-advisors if, is there a convergence among algorithms they’re all trying to optimize in similar ways. And that means they’re all zigging in the same direction as market conditions change.

And are you there? Losing some of that portfolio balance that you’re supposed to be achieving because you’re hedged in different directions. What do you think about all that?

Mike: [00:01:20] So that’s making an assumption that there is a Zig. That makes sense. When you see a zag and there’s not, the market research is clear. You have no idea what’s coming next. Okay. Especially in one to three year timeframes, no one can. Which way you should go based on what has just happened. Okay. So all these portfolios, the robo-advisors are creating are based on historical allocations, trying to be most efficient us international, small, large companies, small companies.

And I believe in all that complexity in terms of having a nice well-rounded diversified portfolio. But they’re also now trying to start to beat the market. Like you say, wow, they’re all gonna Zig or zag in different ways. And they’re trying to do that and convince you that this is efficient, right?

This is a more modern portfolio theory. If you go to these websites, that’s the kind of stuff you’ll be reading. And it’s very effective at saying, oh yeah, this sounds great. Cause they, they couch it in these terms. But the complexity that they’re adding is just over the top. So in terms of your question though, no, , I don’t think that matters too much because they’re all trying to do certain things and this is just passive money.

So your other, but your other comment off-air, which we didn’t start with was, you’ve been reading some research. So while you ask that question around

Matt: [00:02:48] funds

Mike: [00:02:49] yeah, the index funds the correct.

Matt: [00:02:51] Yeah, I, this is all parroting my reading, but the implication was so much. Has gone into a, what was the name of the guy? He died recently, Bogle. who started the whole Vanguard index fund movement and so much money. So much capital has moved into these low cost index funds.

And they’ve taken on the characteristic of zombies. Investing, which means that so much of the market is moving along is just churning along. And the money is just going to sit and not be as responsive to new companies. And it’s not going to, I’m going to use this word again efficiently, try to steer capital toward great new companies or better investment opportunities.

It’s not helping the market to distinguish between. Winners and losers in the marketplace in an intelligent way. Does any of that wash for you?

Mike: [00:03:49] Yeah, so this argument’s actually been going on for awhile. It’s been going on for four or five years or more. And. No, it doesn’t so far, I’m not concerned about it whatsoever. From the standpoint of keeping the market quote unquote efficient. I know what you’re saying. Pricing assets like knowing, oh, this company is going bankrupt.

Like it should be zero. Like you can see the writing on the wall, that kind of thing. And if you don’t have anybody actively trading it, it stays at $50 a share instead of being, $2 a share. So I’m not concerned about it because it only takes a few people. To make the price to set the price.

It does not take very many people trading to do that. So we’ve got a whole industry of people. Analyzing every single company making market recommendations. This is all of wall street. So what they do full time, they analyze companies they’re investing in and out of different sectors, different company, individual stocks there got analysts on all these different stocks.

So I’m not concerned about from that standpoint, you also have a lot of influx of day traders. Lots of message. Boards on all these things. So I think the pricing of assets. I still stay very efficient from that standpoint, because again, it doesn’t take too many people to move this around. You can look at crypto and look at how volatile that is.

And 98% of it never changes hands

Matt: [00:05:04] Well, I was going to actually bring up a similar example. GameStop which was essentially a Reddit message board. Some of it was speculation. Some of it had the characteristic of a Ponzi scheme. Hey, you guys hold. I’m not going to, but you guys really

Mike: [00:05:20] my diamond

Matt: [00:05:20] Yeah. Yeah.

It sounds great for you. Yeah.

So clearly there’s that phenomenon, right? Where people are trying to take advantage of. This kind of like crowd sourcing, let’s all get in on this, make it move. Some of that was also a political statement, a big, what to wall street, but I don’t know.

It worries me a little bit, and I think it’s beginning to worry over. Functions in Congress a little bit as well, that you have a segment of the market. That’s like way over responsive. That is really divorced from price formation, this kind of game stop segment, where they’re not really responding to business plans to research, to business reality.

This is a stock that probably should not be anywhere close to the value at achieved. On the other hand, you have the zombie component of investing all this money in index funds. And it reminds me a little bit of the example of the guy with his head in the ice box and his feet in the oven.

And then on average, he feels fine, but you’re saying, you only need a few rational investors. To in most cases do real price formation and set a market based price.

Mike: [00:06:38] Even the AMC example is. Pretty illustrative of what can happen. It doesn’t take a lot of people to really move a stock. And so that’s interesting. Wow. It doesn’t take too many, a message board can really move these things around. So that’s bizarre and you’re like that company can’t be possibly worth that much.

But if you have an index fund, it’s such a small portion of your index fund, that it doesn’t really matter. What’s interesting is that luckily the company is able to take advantage. Of the craziness and sell more stock and raise a bunch of money. So it may have saved the company that you shouldn’t have been saved potentially.

So that’s interesting. The more interesting thing to me though, around the zombies investing is more the governance. And I think that is a big deal that it used to be. Look, man, you and I would hold a share, some shares of Coca Cola. And we’d follow, like what’s going on with the board.

I We hold these shares. I got paper that says, I own 10 shares of this thing and we’d get some stuff in the mail and it would say, look, we’re having a board meeting and you get to vote, your shares should we do X, Y, or Z? And that has really gone down because now everybody holds index funds.

I’m not getting these proxies or I ignore them because they come through email and my emails overloaded. Or who even, votes them. If you have an index fund, maybe it’s BlackRock, that’s your index fund holder. And they have the voting power because it’s held and street names. So there’s all these different layers of complexity, but in terms of governance, that could be a real issue.

Is she aware that companies now have much more power to just do what they want to because the shareholders just simply aren’t voting. Like they use.

Matt: [00:08:07] Right Because it dilutes the voice of , the shareholders. Does BlackRock actually get an exercise voting? In that scenario, if they’re managing these index funds I seem to recall that maybe they do.

Mike: [00:08:22] Yeah, that’s what I’ve been reading that to Matt. And unfortunately I don’t have it a straight answer to, just give you I know that those fund holders, so there’s BlackRock, who’s massive. Vanguard is obviously massive. That’s who your index fund is through. I think that if you’re invested in the index funds, you’ve given them the right to be voting for those shares.

I think that’s the case,

Matt: [00:08:43] my recollection.

Mike: [00:08:44] Yeah. At least that’s what I’ve been reading. And what are the, how are those guys going to vote? And I think they might even have the option to either vote or pass it through. I’m not sure because that’s been, some of the questions in the media is like, what’s going to happen with all these votes.

Matt: [00:08:55] Either way you could mathematically see how it could be a problem, because either you have three, four or five masks. Purveyors of index funds, holding an incredible voting position in all the companies that make up the core of the markets, or if you subtract all those votes out, it just magnifies the voting power of whoever remains.

And that means that existing boards who may hold a lot of the stock may exercise, proportionally more power. And as you suggested a moment ago, You know that then they get to exercise that they get to essentially without any Rutter Or anchor or any restraining force

Mike: [00:09:40] Or some part of a

Matt: [00:09:41] some don’t look, I’m not a sailor.

Okay. Let’s be clear about that. I actually, I, yeah I canoeing is about as far as I go without any restriction, meaning force whatsoever from shareholders who you have to win over to the stuff you’re doing. They can do what they want. Now. I get the sense that no one really knows what the effect of something like that is it could be totally benign, there could be circumstances where it’s like, Hey, this isn’t so good.

Mike: [00:10:05] Yeah, that’s where I’d be more concerned rather than the setting of prices and keeping the market efficient in terms of, which companies have value and are making serious money, which ones are in trouble, and making sure the share prices are set. I’m not as concerned about that. I think we have a long way to go in terms of, adding to index funds and the zombie investors as you put it.

But the governance thing I think is a bigger question mark, to keep an eye on

Matt: [00:10:28] Let me ask then taking this full circle to the robots. The robo-advisors. What happens then let’s say instead of, the old target date fund, which is essentially an index fund, I am going with a robo-advisor. Is that sort of the same thing, or am I investing in the individual stocks and thereby, am I retaining those voting rights?

Mike: [00:10:54] Yeah. So right now it’s mostly index funds. Robo-advisors are giving you a portfolio of 10 to 20 days. Index funds. So that would operate just as if you own those funds directly. However, we did mention the direct indexing robo advisors are doing that, but also you can go to other places and do direct indexing yourself, but some robo-advisors are starting to do that.

And so they’re yeah, you own, directly. A thousand companies, shares and a thousand different companies and you own them directly. Now, Matt, if you’ve signed up for a robo-advisor and you own a thousand companies, are you really getting all those proxies

Matt: [00:11:27] you could spend your whole, right. exactly. So it has the same effect practically, which is there goes the corporate governance. Now look, I don’t sense that There’s such a huge segment of the market. That’s doing the robo-advising where that’s really.

Mike: [00:11:40] no, but I think the point is we’ve shifted over the last 50 years. It used to be like you’d own five or 10. And you’d have those shares, I believe in Coca-Cola, just a buy 10 shares, or GE and buy 20 shares and you’d own those. And you’d get the proxies and you care about it because you own five or 10 different companies you’d really care.

And in today’s world, it’s buy a Vanguard index fund. I own a thousand companies, and I’m excited about getting those kinds of diversified returns across that whole index fund. But I don’t care about the individual companies.

Matt: [00:12:14] let me let me ask you this. We just did an episode about speculation. Versus trading versus investing. And you pointed out like, first of all, people use those terms a little too interchangeably and they shouldn’t. But look, when my kids are sometimes behaving like maniacs as all kids do, I sometimes just stop them and say, Hey guys, what you’re doing right now. Tell me why it’s good. Just give me the argument for why there’s any redeeming value whatsoever to the fact that you are synagogue of your brother’s head right now. Why is this good? I sometimes have that same feeling when it comes to. Some of the stuff on wall street. Why is it good?

I definitely had that feeling back during the financial crisis. I think a lot of us did where , you’re creating these credit default swaps and then you’re, collateralizing them into these mezzanine CDOs. And then you’re trading traunches of them interchangeably. And I had wall street.

People tell me no, Matt, this really is good because it allows you to manage risk in these super optimized ways, blah, blah, blah, blah. I’m sorry, but I don’t buy it. That has a certain width to it of it’s crossing that line from trading for the purpose of investing to speculation .

And I guess what, I worry about a little bit with the robo-advisor discussion and with, the index fund discussion is I use. Are we losing? What’s good about investing in wall street and about the existence of wall street. If the original point was you have a company, they need to raise capital, they issue stocks so that they can raise capital.

And so that investors can get a piece of their success. So why is that good for companies? It’s good because we need more companies doing good things and creating products and services. This is after all a capitalist economy. Why is it good for me as an investor? Because I can use my brain or I can talk to smart people like you, Mike and I can have people advise me and I could say, you know what?

Coca-Cola, that’s a good one. I don’t like the bet that I’m going to place on Pepsi that no dis on Pepsi. It’s disgusting, but I want to make a bet here. I buy what they’re doing here as a company. And so there was this efficient price formation, the more complex.

That we add through, index funds is decreasing but they’re taking more and more of a role in the market. And then we have robo-advisors and then we have these complicated financial instruments. The more it feels to me, like it’s losing the point, the core point of the existence of a stock market, the good in it for companies, the good in it for investors.

Am I making any sense in any of this.

Mike: [00:15:04] I didn’t really listen to most of it cause I was still stuck on what your kids responded when you asked them, what is the good of you sitting on your brother’s head? What was the answer?

Matt: [00:15:12] They’re all my kids are budding lawyers, they always have a smart answer and it’s usually they cite precedent. That’s dad, do you remember two weeks ago when you said it’s important for people to learn lessons by having painful experiences that they can learn from?

I’m giving my brother a painful experience right.

now. I’m hoping he’ll learn the lesson. Not to let people sit on his head.

Mike: [00:15:34] And my guess is that they throw a lot of the word fair in there. Someone else’s sitting in my head. So this is only fair that I sit on their head.

Matt: [00:15:41] look read the Chris Voss book, never split the difference. He’s the former lead hostage negotiator international hostage negotiator for the FBI, and he has a whole chapter on the use of the word fair and what a loaded word it is and why you should not use the word fair. Yes, you’re

Mike: [00:15:57] I use it all the time now because I’ve just transitioned to life is no longer fair. So I love it. My kids say that’s not fair. It’s just yep. That’s great. That’s why I got you this treat and I didn’t get it for your brother. Cause, cause it wasn’t. And

Matt: [00:16:08] and that’s, why you were sitting on your brother’s head. Cause you should learn that lesson. And now you have, yeah.

Mike: [00:16:14] All right. What was the rest of your questions?

Matt: [00:16:17] The question is there anything good

as we, as we robo-advisors and like index funds owning a third of the market and et cetera, like the more complicated this get, are we losing? What is good about markets?

Mike: [00:16:29] Yeah.

Here’s my take on that is wall street. Is there to sell products. They’re just like any other company just think of wall street as a company, they have to constantly create products that you were interested in buying. And the CDOs and collateralized loans and traunches of things, it’s all creating products that they could sell.

Hey, we did this thing. That’s got this cool spin and all this marketing stuff so that we could sell the robo-advisors are starting to head that way. In my opinion, Index. Are fantastic. They’re very easy to understand and they’re very low cost and they’re very efficient target date funds are just as simple, a amalgamation of a couple of those.

I liked them because they’re very good for the end client. They’re very good for individuals because without any thought you were going to do really well it’s a great. Fund. It’s a great mechanism for you to stay the course over the period of decades and do the eight thing for you without getting caught up with I don’t know what I should do and this and that and the other thing.

Okay. So there. Complexity never favors the buyer. It’s always favoring the seller because it’s complex. So you don’t really understand that map, but let me tell you why it’s going to be great for you. And I can tell you a great story, and this is all products, all marketing, do you really need, this.

Probably not, but it just sounds so great. I’m going to buy that one. So that’s all products and all marketing and that’s what wall street is they’re there to sell products and it used to be the case. Like you said, look, doing the IPO’s and raising funds from individuals.

To do training at all, you needed to go through brokers, but now with the internet, it’s added complexity, but also reduced, costs and ease of access to some of these things that if we can keep it simple for individual investors, that’s where the individual investor was.

Matt: [00:18:20] yeah.

I guess the takeaway for me is, look, obviously my background is in government and to me it’s a useful measuring stick for government. You don’t want to over-regulate, you don’t want to kill innovation. You don’t want to have a heavy hand coming in and, and trying to pick winners and losers, certainly in the market and also get too far into, Hey, wall street.

You can do these products, but not these products. I get all. I do think that it’s a useful yardstick to say, all right why is this good? Why is this. Useful for the market, either for the company side, why is this good for the economy? Why is this good for business or for the investor side? And I guess, look that to me, I know this whole discussion is like a global market governance, the future of markets type discussion.

But I do think bringing it full circle to where you were going at the end there to individual investors who may be listening to this , to me, it seems like if it’s so complicated, That I couldn’t explain it maybe to one of my kids or, you couldn’t explain it to me. I probably don’t want to mess around with it.

And by the way, maybe government really should take a look at it. That’s not my pig, not my farm, but maybe this just is not. Something that we should be messing around with, if we’ve lost that connection to what’s good for me as an individual investor, if it’s simple enough that I can explain it and I can understand it.

What I hear you saying is there are enough good, clear options out there. I don’t have to mess around with the like super duper complicated stuff. I can just do those and I’m going to do great.

Mike: [00:19:51] That’s exactly right. No, I that’s exactly right. That if you can’t explain it, don’t put your money into it. Because we talked about to having a thesis, understanding your process, like what you’re investing in, you have to do that. You have to understand what you’re doing with your money and when to pull the plug on it, why it’s working, why it’s not working.

And the more complex, if you don’t understand, you’re just handing it to someone else and crossing your fingers and hoping that.

Matt: [00:20:13] And hoping that they’re treating you fairly and you’re getting a good deal. All right. Look this started out as a little WebEx extra it’s turned into a full episode. So I’m going to go ahead and close out. This has been an episode of real financial planning with Mike Borton. Thanks for a fascinating discussion.

Okay.

Mike: [00:20:31] it’s great as always, Matt.

Thanks for joining us on financial planning for entrepreneurs. If you like, what you heard, please subscribe to and rate the podcast on Apple iTunes, Google play Spotify, or wherever you get your podcasts. You can connect with me on linkedin or mortonfinancialadvice.com. I’d love to get your feedback. If you have a comment or question, please email me at . Until next time thanks for tuning in.

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