Is Your 401(k) Destroying Capitalism? --- Target-date funds and other passive investments attract the ire of fund managers like David Einhorn

"A respected Wall Street strategist was lambasted when he wrote in 2016 that index funds are "worse than Marxism."

No, Lenin won't be plundering your 401(k), but serious people are again pointing to what they say are the hazards of retirement funds on autopilot -- for America's savers and maybe even for markets themselves. The reason people such as hedge-fund manager David Einhorn are sounding the alarm isn't just the relentless rise of the AI-inspired "Magnificent Seven," collectively more valuable than any foreign stock market, but the huge sums being plowed into stocks and bonds with regard only to price, not value.

Is it just sour grapes? Einhorn, whose hedge fund, Greenlight Capital, struggled for years before a recent rebound, didn't comment, but it is in his financial interest to blame outside forces for poor performance. Even the vast majority of active mutual funds struggle to beat an index despite being cheaper than hedge funds.

The low cost and simplicity of passive investments have obvious consumer appeal. That also has made them enormous. Michael Green, chief strategist at Simplify Asset Management, points to Labor Department rule changes that have put the growth of mostly passively invested target-date funds held in 401(k) plans on steroids over the past 16 years. Those funds alone, just part of the passive-investing universe, are already far larger than all hedge funds combined.

Market leader Vanguard Group, with $1.3 trillion in target retirement funds under management as of January, says three-quarters of large plans it administers automatically enroll employees, with 99% of them defaulting into a "balanced investment strategy" and 98% choosing a target-date fund by default.

Younger employees are more likely to have most of their nest eggs in target-date funds. Their funds, targeting retirement in 2060 or 2065, hold the most stocks -- more than 90% of assets. A glide path to buying less-volatile bonds, and funds' automatic rebalancing, are considered a prudent way to smooth out market bumps and maximize returns.

Another characteristic of target-date funds that some see as a plus and that critics consider ominous is that owners rarely touch them and managers are slow to tweak portfolios, even when they arguably should. 

For example, when the pandemic panic made stocks cheaper on reliable long-term measures than they had been in years, yet bond yields fell to levels almost guaranteed to lose money after inflation, hardly any retirement savers at Vanguard or Fidelity made a change, according to those companies. They aren't doing it today either when bonds look tempting and a handful of richly valued tech stocks are pushing markets higher.

In part because they are so big and managers so bureaucratic, tinkering with target-date funds' allocations happens slowly.

The asset mix goes through a series of committees, according to Roger Aliaga-Diaz, Vanguard's global head of portfolio construction. And while he says Vanguard's own internal models show that stocks are about 30% overvalued at the moment, he says a measure called dispersion shows that individual stocks aren't more out of whack than they have been historically.

Failing to react to market gyrations is generally a good thing for investors. When it is easy to make changes, such as in an actively managed, taxable brokerage account, they tend to be greedy when they should be fearful, and vice versa. 

Academic evidence shows that frequent trading sharply reduces potential wealth over the long term.

The core theory behind passive investing is that other people have already done a decent job of finding out what things should be worth, so an index fund can hitch a free-ride on an efficient market. 

Simplify Asset's Green counters that there is just so much money being blindly invested in already overhyped stocks today, and not enough financial incentive to call the market's bluff on their valuations, that this no longer holds true.

"In order for the wisdom of crowds to work, everyone has to have the same vote," he says.

Einhorn's recent charge that markets are "fundamentally broken" would ring truer if highly valued companies were issuing stock today, starving others of needed capital. Meta, Microsoft, Apple and Google parent Alphabet are instead buying back their shares.

It seems more likely that active management is broken -- or more handicapped than usual.

But if Green and Einhorn are right, then today's famine for investing based on value will become tomorrow's feast. The rub is that, while a patient individual investor could buy out-of-favor value stocks today and eventually beat the market, pros not named Warren Buffett rarely have that luxury.

Fickle investors are giving their money to winners who have no qualms riding AI mania, or are defecting to index funds that do so by default. Being early is the same as being wrong in money management.

But if critics are right, then investors whose 401(k) balances are rising on the back of concentrated portfolios -- particularly younger ones -- could take a disproportionate hit as more baby boomers retire and sell in the same proportion that they are buying today.

And, as in 2022, bonds might not provide a good cushion. "Sequence of return risk" is seen as a pitfall of using bonds as a shock absorber for a target-date portfolio, according to Mike Dever, chief executive of Brandywine Asset Management. Instead of that imperfect hedge, he touts methods of directly protecting all-stock portfolios against losses using derivatives that could leave retirees with more money in the long run.

While his math is intriguing, such solutions can't be scaled up to protect trillions of dollars in assets from disappointing returns. It also wouldn't help if millions of Americans pre-emptively shifted their holdings to actively managed funds. They would hurt the growth of their nest eggs through higher expenses, and many active managers mimic big index funds anyway in order to keep up. 

An exodus from funds overly dependent on megacap tech stocks might itself spark a bear market.

In that way, at least, index funds resemble socialism -- they are so big that we are all in this together." [1]

1. Is Your 401(k) Destroying Capitalism? --- Target-date funds and other passive investments attract the ire of fund managers like David Einhorn. Jakab, Spencer.  Wall Street Journal, Eastern edition; New York, N.Y.. 05 Mar 2024: B.10.