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The following is excerpted from the book, The End of Indexing?, which is available from the link on this page.
“I guess I should warn you, if I turn out to be particularly clear, you've probably misunderstood what I've said”. Alan Greenspan.
Index-tracking is undoubtedly the flavor of the day. Its share of total dollar volume is now in the neighbourhood of one-third of the total U.S. mutual fund market – a market share that continues to grow almost exponentially, and informed sources expect index-tracking mutual funds to have captured more than half of total funds under management within a handful of years1.
With that growth rate in mind, why on earth do I believe the end of indexing is nigh? Well, admittedly, the title for this book was chosen to provoke slightly, but only slightly. Of course, I don’t expect index-investing to disappear altogether. For many years to come, index funds will remain part of the menu investors can select from when making their investments; however, I firmly believe investors will soon begin to realise that the investment environment we are entering is entirely unsuitable for index-tracking strategies, and that they will begin to exit what they have all piled into in recent years.
My logic is based on a combination of structural trends that I have identified over the years. I distinguish between shorter-term tactical trends, which are either cyclical or behavioural in nature, and longer-term structural trends.
The former I try to address with the decisions I make virtually every day. Will oil prices be affected by the latest OPEC agreement? Will the U.S. dollar rise despite many investors already being very long USD? Those sorts of questions are tactical in nature and are obviously important; however, they are not the subject of this book, which will focus on the various structural trends that will affect economic growth for many years to come; structural trends that will be almost impossible to avoid.
Let me caveat what is to follow by saying that the six trends below are only the structural mega-trends I have identified. In addition to those mega-trends, there is also a host of structural sub-trends. I will not go into any level of detail in this book when occasionally referring to one of those sub-trends.
I should also point out that I would never claim to have figured it all out. Just because a structural mega-trend is not mentioned in this book, does not at all imply it doesn’t exist. I could quite possibly be guilty of not having spotted it yet.
With that in mind, the six structural mega-trends that I believe will shape our future are:
- The end of the debt super-cycle.
- The retirement of the baby boomers.
- The declining spending power of the middle classes.
- The rise of the East.
- The death of fossil fuels.
- Mean reversion of wealth-to-GDP.
Before I go into a more in-depth discussion about those six trends, I should add a few important points.
Disruption – another structural mega-trend
I am often confronted with the question – why is automation not on your list of structural mega-trends? Although automation is indeed a very important trend, it is in fact only a sub-trend. Over and above that floats a mega-trend I call disruption, which I added to my list of structural mega-trends days after handing in the first draft of this manuscript to the publisher.
After some consideration, I decided not to write a chapter on disruption. It is admittedly a massive trend, likely to have a dramatic impact on just about everything; however, I need to understand the ramifications better. For example, why do the disrupted sometimes end up on the winning side? An example of that would be music royalties, which has been disrupted by streaming. However, despite being disrupted, the music royalties industry has doubled its growth rate from about 3% annually to 6%2.
As far as automation is concerned, I need to better understand whether an increased use of advanced robotics is likely to lead to higher unemployment. Historically, technological advances have always been good for job creation, but automation is admittedly more significant than anything we have ever seen before in the world of technology.
If unemployment escalates because of rising automation, how much will the decrease in consumer spending hold back the rise in productivity? That said, given the demographic outlook, could exactly the opposite happen? Could a shrinking workforce hold the upper hand during wage negotiations, as robots cannot replace retiring baby boomers quickly enough? If the workforce hold the upper hand, how much could inflation rise?
Also, could robots be the saving grace for the ageing societies across Europe? Could robots man the manufacturing floors in Bremen and Stuttgart, if the Germans no longer want migrants to do the job? Could a rise in automation drive wealth-to-GDP even higher? If wealth-to-GDP equal capital-to-output, and a growing use of robots requires huge amounts of capital, could it be that that the long-term stable nature of wealth-to-GDP is a thing of the past?
Disruption is something we have all been familiar with for many years. An early example of disruption would be digital camera innovators disrupting Eastman Kodak’s traditional camera business. That said, disrupters are not always successful. It is a misconception that entrants are disruptive by virtue of their success. Success is not built into the definition of disruption.
Looking ahead, disruption can only intensify, and automation is only a subset of disruptive innovations coming our way. Yes, driverless cars are not that many years away, and robots will soon be able to do what humans have done for centuries; however, there is much more to disruption than advanced robotics.
For example, think Amazon and think about the extensive damage it has done to retail businesses all over the world. Before long, they may do to banks what they have done to retailers in recent years3.
There are many questions to be answered before I could write extensively on disruption, but rest assured; automation is very much part of my research programme for 2018, so stay tuned.
The common denominator
If there is a common theme running across all my structural mega-trends, it has to be our limited ability to affect any of them. They are all virtually set in stone. Take the retirement of the baby boomers. There is little that can be done about ageing. Yes, we can work a few years longer; hence we can slow down the impact a declining workforce will have on economic growth. Or we can do what Mrs. Merkel did in 2016, when she allowed hundreds of thousands of refugees into Germany, but there is little appetite for that in most countries nowadays.
It is therefore virtually guaranteed that ageing will negatively affect economic growth and financial markets for many years to come, and I could say precisely the same about most of the other structural trends that I will walk you through in this book.
One last comment before I start. Several times throughout this book, I state that capital that could have been used productively, i.e. to enhance GDP growth, is instead used to service existing debt, i.e. it is used unproductively.
You should read observations like that metaphorically. Strictly speaking, not every penny that is used unproductively is used to service existing debt. Capital used to service the elderly is also (at least economically) an unproductive use of capital. So is much of the capital going into the property market (think of the buy-to-let boom in the UK).
History has shown that the lower interest rates are relative to prevailing GDP growth, the more capital is misallocated (i.e. used unproductively). One could even argue (and economists are increasingly doing so) that what is effectively slowing everything down these years is a massive misallocation of capital.
I have even come across the argument that central banks should discontinue their practice of inflation targeting. Inflation is low for a number of structural reasons, and low policy rates do more harm than good now, a decade after the mayhem of 2008. Policy rates should instead be driven by to what degree capital is misallocated, or so the critics argue.
When summing up all the observations and conclusions I am about to share with you, it is indeed hard to be overly optimistic about economic growth going forward. A number of structural trends that we can do little about will hold back the global economy and, when economic growth is pedestrian, corporate profitability can only disappoint.
Unless investors would suddenly be prepared to pay ridiculous earnings multiples for equities (and why would they?), low corporate profitability leads to modest equity returns. All this has led me to conclude that the broader equity indices are more than likely to deliver disappointing returns in the years to come. Simply put, investors need an entirely different approach to investing. Index funds will no longer do the job.
Niels Jensen founded Absolute Return Partners, a U.K.-based asset manager, in 2002 and is its chief investment officer.
1 Source: Financial Times (2017).
2 Source: Kobalt Music Group.
3 In early summer 2017 Amazon announced plans to begin lending to small businesses.
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