Seth Klarman is one of the few hedge fund managers praised by Warren Buffett. His Boston-based Baupost Group is famously tight-lipped and extraordinarily successful, currently managing around $30 billion.
That puts him on par with the endowments of schools such as Harvard and Yale. As it happens, my business partner Scott Puritz and I were classmates of Seth’s at Harvard Business School.
Recently, a private letter to his clients was excerpted in The New York Times. The letter fundamentally warns investors not to get too invested in the “Trump effect” on stocks. The unknowns are many, Klarman wrote.
He has a point, but the more interesting part of the letter, as cited by the newspaper, came later on.
After roundly criticizing his own peers in the hedge-fund business (“To many, hedge funds have to come to seem like a failed product,” he writes), Klarman warned against a long-term distortion that might result from too many investors choosing index funds.
It’s a technical point, but the problem lies in how companies are valued relative to each other in a given index. Too much indexed money could change how markets work, Klarman suggested.
Because of indexing, “today’s high-multiple companies are likely to also be tomorrow’s, regardless of merit, with less capital in the hands of active managers to potentially correct any mispricings,” Klarman wrote, according to The New York Times.
As a result, he went on, “stocks outside the indices may be cast adrift, no longer attached to the valuation grid but increasingly off of it.”
Critics likely will seize upon this as evidence that indexing is becoming a high-risk style of investing, but in my view Klarman’s conclusion is far more muted.
Essentially, he is saying that indexing might create opportunities for long-term value investors who can properly assess the values of companies outside of an index.
It’s hard to argue that Klarman is wrong, especially since he’s speculating about a potential future outcome. But let’s stand back a bit.
Yes, the latest data from the Investment Company Institute shows that net new cash to index funds of all types has grown steadily, rising to $166 billion in 2015 from $28 billion a decade earlier.
Nevertheless, the share of investor money in index funds is just 22% of all equity mutual fund assets. It has gone up by a percentage point or two each year.
That means 78% of investor money in stock funds remains actively managed. Indexing is winning, sure, but it has not yet “won” by any stretch of the imagination.
At Rebalance, what we see is a solid vote of confidence in low-cost investing but far from a market-bending event.
In fact, my partner Scott recently asked a similar question of Charley Ellis, the celebrated investment author, former investment committee chairman of the Yale Endowment and a member of our own stellar Investment Committee.
Specifically, Scott asked Charley: Is it possible at some point that so many active investors will index that the stock market becomes just a means of distributing dividends, that there’s just no growth anymore because there’s nobody out there to trade against?
Here is the edited answer from Charley (the whole interview is here): “It’s intellectually possible to think that way, but you really have to have a pretty vivid imagination to go down that pathway,” Ellis replied.
He added, “If you look at investment management, just imagine if people started indexing more and more and my guess is somewhere around 90% to 95% indexing there would be a turnaround going back the other way. It would make sense to then be an active investor because there would be so little competition. By the time you get there, wow, what a lot of changes will have to have taken place.”
“So, before you get an inefficient market, before active investing can be attractive again, you’ve got to get rid of a huge fraction of the people who are now involved in active investing, and I don’t think that getting rid of half of them would do it. I think you would have to get rid of more than half. Wow, is that a major change.”
We admire Seth Klarman and his achievements at Baupost Group. And we don’t disagree with his assessment that mass indexing might lead to a trading opportunity for someone, someday in the future.
Should it happen that way, Klarman is likely to be among the few able to take advantage.
Until then, having a bit more than $1 in $5 invested in stock index funds today suggests that we have a tremendous hill ahead of us for the indexing approach.
Given the inherent efficiency and power of low-cost investment, we look forward to climbing that hill with confidence.