The featured song in the hit Broadway musical “Wicked” is titled “Popular”. “It’s not about aptitude, it’s the way you’re viewed,” Galinda tells Elphaba, in an effort to spruce up Elphaba’s appearance and image. It failed – Elphaba became the Wicked Witch of the West.
Is the S&P 500 Index on a bull run because its fundamentals are strong? Or because it is Popular? Is it truly aptitude? Or is it the way it is viewed? The same questions can be posed about other indexes, such as the Nasdaq 100 (QQQ), as well as some of the main component companies therein, such as the FAANG companies (Facebook, Apple, Netflix, Alphabet (as opposed to Elphaba)). If the answer is more on the side of that these indexes are going up because they are Popular, then we are heading for a hard and rapid fall once word gets out that they are no longer Popular. People invest in index funds because of their liquidity, but they may not be that liquid once their popularity wanes.
Howard Marks is the legendary head of Oaktree Capital Management, a fund manager based in Los Angeles. Yours truly has had the pleasure of hearing Mr. Marks speak a few times. He writes a periodic newsletter that is posted on the Oaktree website. His most current newsletter was posted this week. In the newsletter, he shows that companies that are components of indexes have outperformed companies that are not index components, all other things being equal. Index-component companies outperform because index investing is currently Popular. This doesn’t make sense for Marks because, if the fundamentals are the same for both companies, then their stocks should be similarly priced, but they aren’t. Marks, a fundamental value-based investor, would buy the unpopular company that is not an index component because the popularity of the index fund is temporary, and the unpopular company will prove to be the better value in the long run. Marks’ overall point in this newsletter, at least in the first part of it, is self-serving: that passive index investing will never fully supplant active investing (such as that which Oaktree Capital does) because there will always be better values through active investing. Makes good logical sense to me.
I agree with Marks that there will always be a place and a need for active investors. Only active investors care about and therefore allocate more of their capital toward companies that do a better job of managing their capital. That’s why I previously stated I believe index funds should not be able to vote in corporate governance issues. However, I don’t believe the market is currently in a Popularity Bubble. Corporate earnings are strong and are projected to grow even more, higher interest rates notwithstanding. There have always been companies that appear to be overpriced (Popular!) and those that are underpriced. It is the job of the active investor to flush out one from another, and it is the job of the index fund manager to ensure that their investors are adequately diversified such that their company-specific risk is minimized. The market will work these issues out in real time.