In a rather provocative article, Stacy Schaus, PIMCO’s DC chief, sounds the alarm about plan sponsors who “engage in a myopic search for the lowest fees possible for their DC plan.” Schaus is referring to the big shift toward “market-capitalization-weighted index strategies that passively track indexes such as the S&P 500 index and the Barclays U.S. Aggregate Bond index.”
Her argument is pretty straightforward. Given the fact that there is this big shift toward market-cap weighted indexing, particularly as it relates to the investing based on the big commercial indices (e.g., the S&P 500), DC investors are being put in the position of having to “keep buying as stock prices go up and will buy more of those stocks the more rapid their relative price growth,” she notes. As it relates to bonds, the plan sponsors buying into a market-cap index strategy are forcing “the DC participant to give more of his hard-earned savings to issuers who are borrowing the most, without regard to yields provided or the ability of the borrowers to repay.”
The concern is that “smart money” may take advantage of these predictable DC buyers by recognizing that the automated process of buying will drive the prices of stocks or bonds higher than their fundamental value can justify. Thus, the smart money will be glad to sell these securities knowing that they will increase in value due to a robotic buying process but that fundamentals will ultimately kick in and they will fall back to a price that is more in line with their true intrinsic value. In short, the smart money is focused more on the true value of the securities and the plan sponsor is focused on the lowest cost of accessing stocks through the buying of a low-cost index fund.
While a plan sponsor may save on fund management fees, it is likely, the argument goes, to ultimately pay a much bigger price once the market corrects the mispricing of securities that is the result of the robotic buying of securities, especially when that buying is based solely on market-cap. The higher the price, the more shares that will be purchased; the more shares that are purchased, the higher the price. The whole process feeds off itself until it blows up.
The most recent period in which there was a great decoupling of price from value was the dot-com era (1997–2000). No doubt, while many smart investors waited on the sidelines for prices to come back to earth, many naive investors rode the markets all the way to the top — that is, until the helium was suddenly released from the balloon.
Some plan sponsors and their advisors may feel that offering a passive target-date lineup is a safe approach to investing in which one cannot lose. Could this thinking be behind a bubble in the making? The fact is that what makes the market bulk up and then contract is always a little different, whether it be the Dutch Tulip Mania in the 1860s, the British Railroad Mania during the 1840s, the Roaring Twenties that preceded the 1929 crash, the Nifty-Fifty phenomenon in the early 1970s (when investors poured money into blue chip glamor stocks that fell about 90% in the 1973-1974 crash), Japan’s Nikkei (which increased more than 450% in eight years and peaked in 1989 — and which today, 25 years later, has not regained even half its value) and the Tech Bubble, when some companies such as Yahoo were trading at 600 times earnings.
And of course, there’s the most recent collapse, The Great Recession of 2008-2009. Who’s to say that the massive shift from active to passive and the automatic investment formulas of buying stocks based solely on their market value is not itself creating a bubble in these large price-weighted commercial indices? Could the steady drum beat — “low cost, low cost, low cost” — be distorting investor patterns and causing unintended consequences? Will DC participants ultimately be the “patsies,” as this article claims? That could very well be the case. Is the “smart money” simply looking to benefit from this lemming-like behavior once it has run its full course?
A greater concern expressed in Schaus’ article is that the focus on low costs and even potential government-imposed caps on fees could accelerate this trend toward passive investing and, thus, increase the patterns described above. In such a case, given the glacial pace at which many plan sponsors make wholesale changes, DC participants could get stuck in what was once a good investment model that goes south. This would be due to the fact that any time a large percentage of investors begin heading in one direction it is often a sure sign that value and price will become increasingly decoupled. Once fundamentals become the means to price securities (as opposed to demand), it all comes tumbling down. Which is to say that this may be more of a challenge in the future than it is today.
PIMCO’s Schaus has begun a discussion that we need to have. There is no such thing as a “set it and forget” method of investing. Plan advisors should follow the number one rule of navigation: “constant vigilance.” What worked yesterday may not be what works today. In fact, what worked yesterday tends to create a pattern for future investing that often has a greater potential to backfire. Investors often discover that the better way to invest is to look at what’s coming around the corner instead of looking in the rear view mirror.
