We talk a lot about index investing at ETFstream. That’s largely because the largest ETFs are traditional ‘plain vanilla’ passive funds, tracking well-known indices such as the S&P 500 or FTSE 100. So if a book is published called ‘The End of Indexing’, we want to find out more about it. I interviewed the author, Niels Jensen, to do exactly that.
As we spoke, it quickly became clear that the title, ‘the end of indexing’, isn’t 100% accurate. The title implies that Jensen is arguing for a return to active fund management. But he isn’t saying that. The crux of his argument is that equities have done extremely well since 1982, and we can’t expect such strong performance in the future.
But if you want to invest in the stock market anyway, Jensen reckons passive is better than active.
‘I don’t think active equity managers are very likely to do any better than passive investors. Therefore you can argue if you want to invest in equities, you should probably still go passive because at least your costs will be lower.’
What’s more, Jensen isn’t exactly mega-gloomy about the outlook for equities. He thinks the most likely long-term return for equities from here will be somewhere between 0% and 5% a year in real terms. Not great but not terrible.
So why does Jensen think that stock market returns are set to be relatively weak?
Well a big part of it is demography. If the working age population of a country is falling, it’s much harder to achieve decent economic growth, according to Jensen. You need big improvements in productivity to make up for the loss of people.
Jensen says that the eurozone’s demographic profile is especially weak and will be a constraint on economic growth up till around 2050. The UK’s in a slightly better situation, and the US better still, but demography is still an issue even there.
Jensen believes an ageing population, debt and the rising cost of energy all make it tougher for developed economies to achieve significant productivity gains. With energy, the issue is that it’s increasingly expensive to find and develop new oil and gas reserves.
‘We’ve picked the low hanging fruit in energy’ said Jensen.
I suggested that new technology might be able to boost productivity, especially AI and automation.
‘That’s typical view of plain vanilla investors. People who haven’t done their homework. The problem with this is for AI to work, for advanced robotics to work, we need invest a lot of money, therefore we need productivity, we need capital to invest.’
In Jensen’s view, there isn’t enough capital, and that means that AI won’t be as big as it could be. Or as big as many currently expect.
So if demographics aren’t favourable, and productivity growth is weak, economic growth will be weak and that, in turn, could give us disappointing stock market growth.
Wealth and GDP
Jensen is also very interested in the relationship between wealth and output or GDP. ‘Wealth/GDP is a measure of capital efficiency of society, how much capital is needed to produce a unit of output.’
Jensen’s research suggests that any country’s wealth/gdp ratio keeps reverting to long-term means that have been established over extremely long periods. So for the US, Jensen says that capital efficiency keeps on coming back to a long-term average of 3.8. Just before the 2008 financial crisis, the figure reached 4.6 in the US, and then fell to 3.7 as the value of assets fell. The US ratio has now reached 5.25, 30% above that long-term average.
Jensen is confident the figure will fall again:
‘I can guarantee it will come back to long-term mean value again. I don’t know when that will happen, but it will definitely happen. Because it’s happened every single time.’
I was curious about the likely falls for different assets classes if Jensen is proved right. Focusing on equities, bonds and property, Jensen thinks that property is likely to take a disproportionately large share of the hit. Equities and bonds will suffer less because pension funds will still have to invest in those assets and also because policymakers will keep interest rates and the cost of capital low.
That said, Jensen made clear that if equities take more of the hit than he expects, then his prediction of annual returns in the 0-5% range will prove to be too optimistic.
What should investors do?
Jensen is focusing on alternative income investments such as aircraft leasing. But he acknowledges that it’s not an easy area for retail investors to get involved with.
In terms of traditional investing in equities, Jensen likes Africa because, you’ve guessed it, he likes the demographics. He said that investing in the South African market is the easiest way to play this trend even if South Africa’s demographics aren’t quite as attractive as some other African countries.
And finally, Jensen likes smart beta, especially value.
‘value will outperform growth. Value almost always does better than growth in a rising interest rate environment.’
Jensen isn’t the first person to say this to me in recent months, but I have to say, I find it a pretty compelling argument.
I also enjoyed Jensen’s other points as well. I agree with a lot of what he says, but I can’t help thinking that he’s perhaps a bit too gloomy on productivity. I hope I’m right!