The Portfolio Reset: Episode 1

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News. John, we're going to start this episode with some number crunching.

Go for it. All right.

So we're going to look at what would have.

Happened if I had taken $ 10, 000 10 years ago. I'm going to do this in dollars just for the sake of argument. And I put it into a variety.

Of different asset classes.

Okay? Okay.

Now, I'm going to start with global bonds. Imagine that I put $ 10, 000 into global bonds 10 years ago. I'd have made in total over 10 years about 2.7%, so $ 266. Pathetic. That's terrible.

That's actually worse than I expected, and I'm keenly aware of how badly bonds have done over the last few years.

Yeah.

So awful.

There are things I could have put the money in which would have done a lot better. Global commercial property, I would have made about 50%. So now I'd have not $ 10, 000, but $ 15, 000. I could have gone into a basket of commodities, in which case I would have doubled my money. I could have gone into emerging markets, the MXEF index, for example, and I would have made 145%.

And then there is, of course, I know what you're waiting for.

I know what you're waiting for. What are you waiting for, John?

I'm waiting for gold.

You're waiting for gold.

And of course, gold would have done better than all of those. My $ 10, 000 would now be $ 32, 000.

So that is very good. And of course, we like gold and well done gold. But of course, it's not the winner.

Something did better. I reckon all of our listeners know exactly what that was. But for the sake of argument, John, what do you think?

Is US stocks or the S & P 500 to be specific?

Despite the worries over tariffs and a possible AI bubble, American markets had a stellar year and we're at new highs today.

The MEX 7 is the way to go.

It's going strong.

You've got to stay invested in.

The MEX 7.

Chart, this longer term chart going back to 2011, maces us that there could be more gains ahead.

We see a beautiful uptrend of the bull market.

We're not even halfway through the month. We're already up over 4% on the S & P 500.

For this month. For this month alone.

That is exactly it.

Now, if I put that same $ 10, 000 into a super simple S & P 500 tracker fund, middle of August 2016, I would have $ 41, 000. So I would have made over 310%, which is an awful lot better than 2.7%.

That is a pretty extraordinary investment.

And when you look at it, you look at that, you look at those numbers I've just given, and it totally explains why everybody invests the way they invest today. Look at that and you think to yourself, well, why would I do anything except for just buy a cheap S & P 500 tracker and hold it and get on with living. Wipe out stocks, wipe out fund manager, well, worry about which markets are cheap, which are expensive.

Yeah, and a lot of people have actually thought that way.

And that is why we have seen this massive rise in passive investing. It's gone from something kind of niche to something that is actually the default. New investors come in, they buy the index, they keep their funds low, they don't fiddle with it.

That's that.

Okay, so what's the catch?

Maybe there isn't one. Maybe, okay, there is.

Those numbers tell you what worked over the last 10 years. They do not tell you what's going to work over the next 10. And there is a question to ask about that. Is the investment strategy that won the last decade necessarily the one that you want to follow for.

The next decade?

Welcome to our special mini-series, The Portfolio Research, getting your money to do more. I'm Meryn Somset-Webb, editor-at-large for Bloomberg UK Money and author of the weekly Meryn Talks Money newsletter.

I'm John Stebbick, senior reporter and author of the daily Money Distilled newsletter.

And over three episodes, we are going to question some of the assumptions underpinning investment today, how to think about what that might mean for your own strategy. We'll start with talking about how lots of investors became convinced that passive was the smartest, perhaps even the only, way to invest.

It's got to the point where everyone thinks that passive investing is itself some solution.

And how the rise of passive has combined with a lengthy period of outperformance by the US stock market to create risks that many investors may not be entirely aware of.

You end up with what looks like a market concentration in seven companies.

That's part of the reason.

why everything is so expensive.

There's no guarantee that just because the market has had an amazing run, the future will be like the past at all. This means that investors building and reviewing portfolios today may need to reconsider their assumptions about the recent past and change their approach accordingly.

You've got to think differently.

You've got to diversify properly and you've got to capture alternative assets.

And at the end of the series, we are going to dedicate a whole episode to answering your questions. So as you listen, be sure to email us at mirrormoney at bloomberg.net. All right, John, before we go any further into this, we need to take a step back. Let's have a go at defining what it is that we mean by passive investing.

Passive investing is when you're simply building buying the market. And the purest expression of what passive is, is to buy a market cap weighted tracker.

That's Simon Evan Cook, fund manager at Downing Fund Managers. And the important bit there is this, you're buying the market. You are not paying someone to decide that this company looks cheap, that company looks expensive, this one's going up, that one's going down, all that stuff.

You own the lot.

Easy. Yeah, but in this particular case, you don't own equal amounts of the lot.

That's a very important distinction. And he explains this by looking at the example of the FTSE 100, which is simply an index of the 100 largest companies listed on the London Stock Exchange by their market value.

So in the UK, let's say that's the FTSE 100, you will be buying those 100 companies within your tracker, but you will have much more exposure to the biggest companies within the index, the likes of a BP or a Shell, for example, than you will to company number 99 or 100.

So the bigger a company gets, the more of it you own.

And take that across the Atlantic to the S & P 500, and you can immediately see why this matters.

Because what's sitting at the top of the S & P?

It is the enormous American technology companies, the Magnificent Seven. So that's Apple, Microsoft, Alphabet, Amazon, Nvidia, Meta, and Tesla, what we call a Mag7. And as these have become more valuable, they've become a bigger and bigger part of the index.

But John.

Here is the thing with all this. Passive investing now feels so obvious, as we said, it's the thing that everybody does. It's now become quite easy to forget just how radical, how innovative, how extraordinary the idea once was.

Yeah, because in the old days, you couldn't easily track an index. You just had to pay money to a fund manager or a financial advisor and give them a big commission to find what, in theory, were the best investments for you.

But then things changed, thanks to John Bogle.

Picking stocks or funds, finding that elusive needle that will give you what you think you want in the future is very difficult. We all know the metaphor of finding a needle in a haystack. It means forget it. It's not worth trying. And I would argue the same thing here. Own the haystack means own the entire U.S. stock market or the entire world stock market. And don't do anything once you get the haystack. No more looking for needles.

So John, or Jack as he was sometimes called, founded Vanguard back in the 1970s. It is now one of the world's largest investment companies.

His two big ideas were really democratizing investment and bringing it to everyday investors. He really started to realize, based on a lot of academic work that had been done while he was at Princeton, that actually, if you bought the market, you could actually lower costs. You don't have to spend money in hiring active managers who have to pick winners, which is actually quite difficult to do.

So the proposition here was wonderfully simple.

Stop trying to find the cleverest person in the room, buy the market, keep your costs low as possible and stay invested.

Jack Bogle's vision was investing shouldn't just be for the rich and the wealthy who can afford to pay high fees for active management.

And that was actually arguably the most important point in his favour. If you don't have a human fund manager to pay, then It's far cheaper to just track these stocks.

What Jack Bogle realized was that actually you could buy the market and do better than the average fund manager because the average fund manager in theory will be the market. And if you're paying lower charges than the average fund manager, you'll do slightly better than average.

That is Simon Evan Cook again making the killer argument.

Yeah, it's just basic maths.

It is, it is.

But full cost to the average investor.

Is the market.

After costs, the average investor, by definition, has to do worse than the market, right? So if I can simply own the market and pay almost nothing to do it.

Then you're already ahead of an awful lot of people who are paying rather more.

Anyway, the arrival of passive funds then put huge pressure on the old-fashioned active investing model, which, by the way, was not a bad thing.

They forced fees.

Down, they gave ordinary investors cheap diversification, they made investing simpler, and they made it accessible... So we need to be absolutely clear, John, before we move on to complaining about this, that passive investing was an absolutely brilliant invention. But there's another reason passive investing has become so widespread. It's been perfectly suited to the market investors found themselves in.

We'll explain more on that. after the break.

So Meryn, passive really took off in the 1990s and especially the 2000s because the market looked very different then.

Very different. There were thousands of listed companies back then.

Successful companies tended to come to the stock market pretty early in their lives. So if you wanted exposure to the growth of the economy across the board, a pretty good place to find it was the public markets.

By the market really actually did get you quite a lot of the market. You also had ETFs or exchange-traded funds.

The exchange-traded fund.

The ability to package an index into something that you could buy and sell on an exchange as if it were actually a share itself.

Now, these were introduced in the early 1990s, but at that point, they were mostly used by institutional investors. It wasn't until the 2000s they really became big with retail investors. But when they did, they really did become big. They turned passive investment into a mass market product. and also meant that unlike the original tracker funds, you could buy and sell during the day if you wanted to. And also online broking was becoming a much bigger thing then, so you could just sign up for them through your ordinary online account, you know, R. Graves Lansdowne, Charles Schwab, E-Trade, depending where you are. And obviously this took the essential idea of an index fund, but it made it even

more accessible, even more flexible, and even cheaper for the everyday investor.

ETFs made the whole thing even more convenient.

You know, you didn't have to do anything except for go into your account and buy and sell. And at the same time, benchmarking became much more important. Investors increasingly knew exactly what the market itself had returned. And there's widespread information available to ordinary investors. You can see what the market as a whole has made people. And then you can see how much your expensive active fund had failed to keep up with the market. And that created rather a powerful feedback loop. Active managers underperform.

Which they mostly do.

Investors move their money into index funds and ETFs. Passive funds gets bigger and bigger and bigger and cheaper and cheaper and cheaper. More money flows in and the evidence for going passive over active becomes more and more compelling.

But then into the financial crisis and the rise of the MAG7, which you're starting to see from the 2009, 10, 11, 12 onwards, you've seen passive take another massive leg up to the point now where we've passed the point by many measures where it's more than half the market.

Now, we should be careful with that half the market figure, right?

Because people bandy these numbers around, but actually measuring precisely how much of the market is passive is really surprisingly difficult.

It's not that easy.

Yeah, but the direction of travel isn't very hard to spot.

No, that's fair.

Definitely getting bigger and bigger, gone from insurgent strategy to mainstream strategy.

Okay, so we've established that Bogle's popularization of passive investing changed things a lot. It brought more investors into the market, made everything cheaper and much more accessible. So it was a good thing. We also established the rise of ETFs in the 90s and 2000s, made it even easier and even more accessible. And then after the financial crisis in 2008, passive really accelerated in adaptation as people lost faith in financial institutions in general and were looking to cut the cost of investing even further.

So now we need to recognize that as passive investing became more mainstream, something else was happening, a worrying increase in market concentration.

And that's important because remember, the more concentrated the market becomes, the more concentrated investors' portfolios become too. And that's especially so in a market dominated by passive investing.

And we bring this up because this entire series is about thinking about why passive investing, this really popular strategy of buying and holding an S & P tracker, isn't necessarily a perfect strategy. So the very word passive makes it sound as though you're making absolutely no decisions at all. It's literally all done for you. Only decision you have to make is to passively invest. And that is that.

You're just buying everything. Job done. But of course, you're not actually buying everything. You're buying an index.

And an index is just a set of rules and judgments about what counts and what doesn't. In the same way that an active fund manager makes decisions about what they're going to put in and out of a fund, an index provider does kind of the same.

Even the indices that you're tracking have made decisions. The S & P 500 is a market cap weighted index. That's a decision.

That's Paul Kearney, executive chairman of Asset Risk Consultants. He advises family offices and foundations on their investment strategies. He's been in the wealth space for more than two decades and has worked in private banking and investment consulting. Paul mentions the market cap weighted index. That's the one where the index gives larger companies a higher percentage weight in the index. So the bigger your company, the more of the index you make up.

So there are judgments being displayed everywhere in the construction of the indices, as well as which index you're choosing to follow and which mix of the indices you're choosing to put together.

So there's the point. Someone makes the decision.

And the risk, of course, is that the investors don't think about the fact that they are actively making decisions.

And as Simon talked at the beginning, most of the trackers we're talking about are market cap weighted. And that means the more valuable something becomes, the more of it you own. And that's all very well while the thing that is becoming more valuable keeps on becoming more valuable.

Until maybe it doesn't. And you can see where a problem has crept in.

Because over the last couple of decades, one market has become vastly more important than all the others.

The United States.

It's quite hard to remember a time now when American dominance didn't feel completely inevitable. But our Bloomberg Opinion colleague, Senior Editor for Markets John Authors, does remember.

I think it's now 20 years since I had a story on the front of the second section of the BFT when European market cap overtook US market cap.

Imagine that. Europe overtaking America.

I don't know that anybody thought that it was quite as inevitable as people feel American exceptionalism is now, but they did think it was going to continue.

And let's not forget that America had a pretty miserable start to the century. Those first nine years, it returned almost nothing, and everything else outperformed, even when the FTSE 100 massively outperformed the S & P 500. How did we get from the U.S. being a, frankly, really very poor investment to a world in which the U.S. market feels almost entirely unaffected?

Beatable.

Single biggest reason is the US has tech and those have become dominant global industries.

And that transformation matters enormously for passive investors.

Let's say you think you're doing the most neutral thing imaginable. You buy a global market cap weighted tracker. But what have you actually bought?

You've bought America and you've bought a lot of America.

Look back the bit we were just talking about underperformance for the US. Back then the US market was a under half the MSC World Index, but no more. Buy that same index today and you're buying 70% America and almost no UK, for example. So the market is being dominated by a country. And within that, you've got stocks that are much more dominant as well.

And it has still outperformed, which has been great.

Absolutely.

It's been fantastic if that's what you've had. But there's a really important distinction here between saying, yes, this worked extremely well, it's been absolutely fantastic, and saying, this is diversified, this is a good strategy. And then, of course, there's the psychological effect. The longer this American outperformance continues, the less it feels like outperformance and more it feels like just the way things are, the natural order of things.

Here's Paul Kearney again.

I think it's had a dramatic impact. I think it's sort of become the only show in town. The challenge that gives is that the longer it goes on, it feels normal. This concentration feels sensible because it's been successful, but it is a concentrated bet.

Let's think about what Paul is actually saying here for a moment. He is saying that concentration feels sensible because it's been successful.

Yeah, and successful investments are a remarkable habit of making the risks that got you there look rather less risky with hindsight.

So Paul isn't saying, and we are not saying, that U.S. exceptionalism might end tomorrow and suddenly you'll feel the risk.

Yeah, I mean, it could carry on for years, conceivably.

Yeah, yeah, it might. It might.

But that is not the point. The point is that a portfolio can be enormously successful, but also very concentrated and hence kind of risky.

It's not unusual for a fair amount of concentration to occur and for at any one point there to be some very clear winners and some clear losers. What we're seeing at the moment is unusual. The dominance of the top 1, 5, 10 is the last I checked, all-time records.

And it has continued to intensify.

So that's the first big challenge to the passive investment strategy. Extraordinary concentration, first in the US and then in a handful of giant tech stocks. Now, you may be wondering why we're telling you all this. What's the takeaway from it? What it means is that you're thinking about your portfolio or the things that you have in your portfolio, possibly in slightly the wrong way.

Right, John?

Yeah.

Basically, there might be an awful lot more of specific stocks in the unspecific countries than you expect. or believe, and is far less diversified than you might currently think.

So when you're looking at it, you need to look at it through that prism. What's really inside it?

But even concentration risk isn't the end of the story. In the next episode, we look at another shift that also changes the picture.

Companies go from, you know, zero dollar valuations to trillion dollar valuations.

And it involves companies like SpaceX, Anthropic, and OpenAI.

Everyone thinks that there is gold at the end of the rainbow. If you're excluding yourself from investing in that, how much are you impacting your returns?

Put all of these changes together and you get to a slightly paradoxical conclusion. If you want to invest passively, you may need to make some very active decisions about where your money goes. Thanks for listening to this first episode in our three-part investment series. And as a reminder, we will have a final episode addressing listeners' questions. So please do send them into our show email, merinmoney at bloomberg.net.

You can send that in as an email or a voice note. We might even play your question on the show. And as always, if you like this episode, share it with a few friends and leave us a review wherever you listen to podcasts. This episode was produced by Summer Saadi, Moses Andem, and Jennifer Seeley. Amy Keene is Executive Producer for Talk Podcasts And Cheryl Brumley is head of our podcast.

We'll be back next week with more.

The Portfolio Reset: Episode 1

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