Markets

Nir Kaissar is a Bloomberg Gadfly columnist covering the markets. He is the founder of Unison Advisors, an asset management firm. He has worked as a lawyer at Sullivan & Cromwell and a consultant at Ernst & Young.

The money mavens have peered into their crystal balls and they foresee trouble. Just don’t ask how much  because investor behavior has turned a new shade of unpredictable.

Jeffrey Gundlach, the co-founder and chief executive officer of DoubleLine Capital LP, said on Tuesday that risky assets are overvalued and that investors should be “gradualistically moving toward the exits.” Just two weeks earlier, Howard Marks, the co-chairman of Oaktree Capital Group LLC, warned that investors are engaging in “risky behavior.”

On Wednesday, Pacific Investment Management Co. and T. Rowe Price Group Inc. joined the chorus with fresh warnings. Pimco urged investors to move money from U.S. stocks and high-yield bonds to less risky assets. T. Rowe Price is paring its investments in stocks and high-yield  and emerging-market bonds.

It doesn’t take clairvoyance to see that some assets are frothy, just some simple math. According to Yale professor Robert Shiller, the cyclically adjusted price-to-earnings ratio of U.S. stocks is 30.5, almost double the historical average of 16.8 since 1881.

High-yield and emerging-market bonds, too, are twice as expensive as their historical average. The 12-month yield on the Bloomberg Barclays U.S. Corporate High Yield Index is 5.9 percent, compared with an average yield of 10.3 percent since 1987. And the yield on the Bloomberg Barclays EM USD Aggregate Index is 4.7 percent, compared with an average yield of 8.6 percent since 1993. (Prices and yields move in opposite directions.)

How Low
Emerging-market bonds have never been more popular
Source: Bloomberg

It’s reasonable to assume that asset prices won’t hang around those lofty levels forever. But this is where the crystal balls get cloudy. Gundlach and the other doomsayers don’t say when the sell-off will start or how much asset prices are likely to decline. Those predictions are notoriously difficult, and this time there’s a new variable to consider: Investors haven’t been themselves lately.   

Investors have a well-deserved reputation for overreacting, which during previous downturns has caused asset prices to plunge below any reasonable semblance of fair value. There are numerous examples. After the 1997 Asian financial crisis and the 1998 Russian financial crisis, the 12-month yield on the emerging-market bond index spiked to 13.9 percent in 1999 -- three times the current yield and well above its historical average. The same thing happened to the high-yield bond index during the 2008 financial crisis; its yield jumped to 16 percent in 2009.

But investors may not be the lemmings they used to be. It’s well known that a huge number of them are ditching high-priced active managers in favor of low-cost index funds. Investors have plowed $3.4 trillion into index mutual funds and ETFs since 2007 through July, while traditional actively managed funds have attracted just $288 billion.

Smart Money
Investors are ditching high-priced traditional active management for lower cost options
Source: Morningstar
Note: Flows for 2017 through July.

Less known, however, is that those index investors have been uncharacteristically disciplined about sticking with their investments.

According to Morningstar data, investors in U.S. stock index mutual funds captured on average 96 percent of their funds’ returns over the last 10 years through July, whereas investors in actively managed U.S. stock funds captured just 71 percent of their funds’ returns.

Hang On
Index investors have been more disciplined in recent years than investors in traditional actively managed mutual funds
Sources: Morningstar, author's calculations
Note: Index funds include smart beta.

Index investors were more successful in overseas markets, too. Investors in emerging-market stock index funds captured 85 percent of their funds’ returns compared with 33 percent for those in active funds. And investors in developed international stock index funds captured 92 percent of their funds’ returns, while investors in active funds lost 0.4 percent annually despite the fact that their funds eked out a gain of 1.9 percent annually.  

The fact that index investors were able to hang on over the last 10 years is no small feat because markets handed them plenty of opportunities to make bad choices. Remember that the last decade includes the 2008 financial crisis. And overseas markets doled out other hairy moments. The MSCI Emerging Markets Index, for example, dropped 26 percent from May to September 2011, including dividends. It also plunged 29 percent from September 2014 to February 2016.

Wild Ride
Emerging-market stocks have handed investors more than a few scares over the last decade
Source: Bloomberg

With the surging popularity of index investing, investors may not be so quick to flee for the exits at the first sign of trouble. Maybe it’s best to hold those predictions.   

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Nir Kaissar in New York at nkaissar1@bloomberg.net

To contact the editor responsible for this story:
Daniel Niemi at dniemi1@bloomberg.net