The listeners have questions

0:05Pushkin. Happy New Year. Yeah, we've had a blast doing these podcasts over the past year and a half or so. And one of the best things about it is we get nice emails from listeners. Mostly nice. Anyway, lately, we've been asking you for your questions. What do you people want from us? Well, you delivered your questions. We got lots. And in today's show, pre-recorded before we head off to eat, drink and be merry, we're going to answer as many as we can to kick off 2025. 25. This is Unhedged, the markets and finance podcast from the Financial Times and Pushkin. I'm Katie Martin, a markets columnist here at the FT in London, and I'm joined by the dynamic duo in New York from the Unhedged newsletter.

0:51First, Sea Lord Rob Armstrong and Abel Deckhand Aidan Reiter. Yeah, man. Ahoy. Ahoy. Here we go. Chaps, Happy New Year. Happy New Year to you, Katie. Happy New Year. It's going to be a great year, Katie. It's going to be a biggie. Now, are you going out at New Year people or staying at home and getting drunk at New Year people? I drink at home on New Year's. And I'm generally asleep before the ball drops, as we say here in New York City. I find the whole thing rather a bore. I go out, but I get very cranky very fast. Yeah. I mean, it's so crowded. In New York City, it's like a mob scene and it's not fun.

1:29You basically got to barricade the door and stay home. What a curmudgeonly pair you are. Now, we got loads of questions in our mailbag, and quite a few of them were about passive investing, which, as you will know if you've heard me talking about passive investing before, is a really good way of starting an argument with a markets person. So I guess a lot of these questions sort of settle around the idea of, is passive investment breaking markets? So we got a question, and I'm going to pronounce people's name wrong, and I'm sorry in advance. It's all part of the service. It's all part of the show, boys and girls.

2:07We've got a question from Philip Fratchel, who asks, are investors missing opportunities outside of indices because of passive investment? And are companies prioritizing index inclusion over fundamentals? Hmm, interesting. Rob, why don't you kick off by, like, for the uninitiative, what is passive investment? So passive investing is investing through funds that own plus or minus the whole market or a slice of market. So you might have a fund that owns the whole S &P 500. You might have a fund that owns every publicly traded stock in America. You might have a fund that owns just the small ones or just the ones that are in industrials or health care or whatever.

2:51But it's a way to get exposure to the market or market segments without picking individual securities. And I would also say this is one of the great things in my view. I am strongly positive on passive investment. It is how I invest my own money. And it is low cost. And it captures the first thing that investors should want to capture, which is the general upward movement in equities over time. The beta in the market, the beta return. And so yay for passive investing, says Armstrong. Yay for passive investing. But Aidan, what kind of problems is this like throwing up? Is there an argument, as our correspondent Philip asks, that they are penalizing companies outside of indices and actually investors are missing opportunities here?

3:44I think there's definitely a very real rationale to his argument, right? So if you're just buying all the stocks in an index or buying all the companies in the sector, A, if you're having companies outside of that, as he said, then they're not getting included. They're not benefiting. And those could be the diamonds in the rough. That's ideally what active investors are going to try to find. But if the rest of the market is not paying attention to that individual company, that could either be a good thing for them, right? They buy it and then theoretically they have success, later get into the index and they owned it low and then it went and skyrocketed when it was later included.

4:18or again, you know, they get trapped out of the money they otherwise would get. So I see it both ways. I think at the end of the day, though, it's probably a net good thing for people's retirement portfolios and probably the market at large to have people investing in broad sectors. So yes, there might be some losers, but for the most part, it's probably a good thing. I'm probably going to get this number wrong, Katie, but I think now it's slightly over half in the U.S. of assets that are in passive funds. I think in 2023, it was like 15 trillion in passive and 14 trillion in active. Something like that.

4:54So the question is, how many active investors do you need relative to the passive investors to keep the market honest? So when I buy my assets - How many stock pickers does the universe really need? Really need because you want the prices to be efficient, right? You want somebody out there caring about individual stocks and what they're worth and deciding some should be sold and others should be bought and evaluating, you know, keeping the market efficient. And as far as I know, no one has proposed a proportion that is required. However, I have a guess, which is not very many. The market could become more passive than it is now before the prices all get kind of stupid.

5:35So I was talking to a fund manager the other day who was saying that one of the problems that's introduced into the system by passive investment is that say you're an old school stock picker, right, an active investor, and you find like a little company that's a little diamond in the rough that not enough people are paying attention to. And you think I'm going to buy this thing because I think it's going to go up. And I think that at some point at a later date, the rest of the market is going to see the good qualities in this company that I can see now that other people can't. And the problem is that now that so much of the market is passive and it's all tracking an index, it's difficult to identify that next buyer, that next individual.

6:13So in a sense, it does make life difficult for the smaller companies that are outside of the big indices, because passive eats active over time. And, you know, just the weight of index tracking investment does make life difficult for active investors. Now, in theory, it means there should be more opportunities out there for investors who are clever enough to spot enough of these diamonds in the rough. But at a certain point, they do need someone else to sell to, right? If they got a diamond in the rough, and then later on, it gets included in one of these passive indices, that's a huge return.

6:43And certainly when stocks enter the big indexes, they get a big pop. Like it helps. It helps. You get a valuation premium for being in one of the main indexes. There's no question about that. And that we file under life is not fair. Yeah. So does that answer actually the second part of Philip's question, which is are companies prioritizing index inclusion over fundamentals? Is our answer probably yes, but life's not fair. But yeah, probably yes, but it's hard to do. So to be included in the S &P 500, you have to have a certain amount of market capitalization and a bunch of other requirements. So you can't just will yourself into the index.

7:25You have to run the company well enough that you meet the demanding criteria that the indexes propose. So I don't know. I don't know what it would look like to like in some irresponsible, bad management way, try to wheedle your way into an index. I don't know if that's really a thing. The roll ups maybe, but nobody, M &A is essentially frozen right now. So yeah, perhaps by buying things. But one of the things about passive investment is that every now and then some clever clogs kind of raises their hand and says, oh, well, you know, these things are going to break markets. They're going to cause all sorts of trouble.

7:58You know, you wait and see. You know, as soon as you get a big shock to markets, these things are all going to break. Nah, evidence for that is pretty poor, I've got to say. But, you know, the next time we have a major market puke, and who knows when that will be, but when we do, that will happen in a market that is much more passive than the major market, last major market puke we had. Maybe call that 2008 or whatever. Well, 2020 was some pretty good puking. and there's an idea that the passive investors will exit the market in a disorderly way and because they're selling index products everything will be sold at once yep and this is bad but on the other hand my experience of these kinds of pukes is that everybody's selling everything everything all at once anyway exactly that the whole point of one of these markets is that it's indiscriminate selling and people are just getting rid of whatever they can you know so yeah yeah Yeah, so plus, ça change.

8:54So I'm not worried. I'm put, again, at the danger of repeating myself, passive, good, not worried about it. Yeah, passive and chill, says Rob Cheapskate Armstrong. So here's a fun question from Richard Ivers, who is asking, what metrics or trends do we think are most underappreciated by investors today? Hmm, intriguing question. Katie, you have to, we've been talking, you talk, you start. That's such a hard question. Well, I think one of the things that is most underappreciated is humans and human incentives. And by that, I mean, there's a lot of movements that you get in markets and assets that come in and out of favor that hinge in quite a large part on what we call career risk for fund managers.

9:45Right. So fund managers, you know, if you if you run a portfolio of money for a year, you don't want to get fired for doing something stupid, especially doing something that's stupid and obvious that at some point it would go wrong. And so that prevents a lot of people from actually making investments that make a lot of sense sometimes. And also it's just quite it's quite an important factor over how what investors do. And also I think there's quite a lot of how fund managers are remunerated that actually is quite impactful to how markets move. So you will notice, right, it's December. Markets are pretty quiet in general.

10:25A really big reason for that is that a lot of portfolio managers' bonuses are decided based on their performance up to about the beginning of December. And after that point, what is the incentive to take on risky bets over the rest of that? months. Yeah, that's a fair point. I would only add one of the most important places for markets where you see career risk having an effect is moments like today when stocks are very, very richly valued as they are in the United States. And it feels like we're in a bubble because somebody who is running an active fund, it is almost impossible for that man or woman to say, actually, I think these valuations and these prices are scary.

11:11I would like to have a large allocation to cash in my fund. And they may think this would be the wise thing to do. But if they do it, and there is not a big correction in the markets like the one they are worried about, they are fired. Yes. Because they will have underperformed. So it's like, so if you're going to do something stupid, at least make sure everyone else is doing it. So this time next year, when you're talking to your boss, you can say, look, I know I bought US stocks and they were already looking really expensive, but everyone else did it too. No one could possibly have known that this would go wrong.

11:47So the lemming effect is very important. I agree with you. Are there any actual indicators you guys look at, like in the market, stock prices or currencies that you think are underappreciated by investors or that are helpful to you as you write columns? Well, one thing I think about a lot that I think, and anybody who reads Unhedged will have heard me rattle on about this at tiresome length, is I think the U.S. federal deficits are very good for the stock market. That when the federal government borrows a lot of money and pushes it into the economy, unsurprisingly, that makes stocks go up. So I think people don't appreciate how beneficial the wild fiscal binge the U.S.

12:34has been on is for stocks and how potentially hazard it is for stocks and other risk assets if the government gets religion about balanced budgets and austerities. I would consider that a major risk to the stock market. And most people you talk to think it's the other way, where if the government is careful and thoughtful about deficits and watches every penny, that's kind of good for business. As if America was like this giant household where if it saves carefully, there will be prosperity. But a last note is the exact opposite, I would argue. So I think that is something that investors should probably think about more than they do.

13:13So, yeah, I've rattled on about emerging markets in the past, but I find them interesting. They're very good at picking up things that are not going well in the U.S., right? So if rates are high or inflation is heating up in the U.S., the first place you'll see that is in emerging market currencies or emerging market debt. So I think they are not necessarily underrated by the market. I think the market is looking at them. I just find it interesting to follow. And because they've had bad returns like the last five or 10 years, people tend not to follow them. Yeah. But I am old enough to remember.

13:41Now, there's a phrase I find myself saying more often than I would like. Same. I am old enough to remember when in like the early 2000s when people were like, why would you ever own anything but emerging markets? That's where the growth is. It's so true. Et cetera, et cetera. And now it's literally the opposite. You mentioned emerging market stocks to people and they laugh in your face. Yeah. I think also emerging market currencies are a really good indicator of things that might be going wrong. in modern portfolios, you have everything balanced. It's a complicated weight balance act. And if you see a huge sell-off of the Brazilian real or the Japanese yen, it means something's not going well on the other side of that portfolio.

14:20And we saw that play out this July. We sure did. Good point. Yeah. Yeah. Okay. Look, we've got to crack on with another question. If US stocks are in a bubble, what can you do about it? How can you protect your portfolio? And on a related note, question here from Andy Foote, like what might be the catalyst for Europe to catch up? Because I guess the question here is like, if US stocks are in a bubble, right, you accept that as a premise. One of the things that is seen as like the potential catalyst for that bubble popping is another outbreak of inflation in the States. Yes. The problem with that is if that happens, that's no good for bonds.

15:01So the bond bit of your portfolio is not going to save you. And people have got super short memories, but that's what went very much belly up in 2022 when everyone lost money on everything. And it was absolutely brutal. It is awful when stocks and bonds are correlated and you have a route that is just the baddest of bad, all bad things. No good. Very, very bad. No good thing happening. So, OK, so if we think that U.S. stocks are in a bubble. Well, one thing that's nice about this moment right now, and I'm speaking because I've done a bit of this in my own portfolio, is you can hold a bit more cash now or cash-like things, very short-term things.

15:42And the thing that's nice about those is that for the first time in a long time, those offer real returns. So, you know, you can get a 2%, 2.5%, 3 % inflation-adjusted return on cash. So I think it makes a lot of sense if you're worried, if you're highly exposed to US stocks, which my portfolio is, and you're worried about the downside, which I am, increase your allocation to cash. You get a little something. And if the bad thing does happen, you have some firepower to buy the U.S. stocks back when they get cheap. But there's always the tax problem, right? The problem for like an individual investor is you sell stocks, even stocks you've held for over a year, you're taking a 15 % hit right off the bat for your capital gains taxes.

16:32So you have to think, do I really think it's going to be worse than 15 %? That's got to be, you know, a 10 % correction. If you sold ahead of a 10 % correction, you've lost money, right? Yeah. But to the tax man, of course you have to always pay tax eventually. You know, it's a matter of just when you want to pay them and et cetera, but it's an issue you got to think about. So traditionally one would say, that's why you have 30 % of your portfolio in bonds. But you just made the point, Katie, and I think it's really important that we just had an inflationary incident. This is stagflation is what we're talking about.

17:05That kind of thing can happen again. And you can have bonds and stocks become correlated when there is inflation. And that means your stocks could fall and the bonds could fall at the same time. And the difference with cash is it is not sensitive to rates in the same way that a normal bond portfolio would be. So on the second point of that question, the question from Andy, like what is the catalyst for Europe to potentially catch up? Now, I've been banging this drum for a little while. I think people are too nervous about Europe right now. So, you know, stuff that can go right for Europe include, Right.

17:46Currently, France is a mess. It got itself into a mess. It can get itself out of a mess again. Germany's got some elections coming up where it might decide that actually it's not so allergic to, you know, to tax and spend as it normally is. Maybe it could get a bit looser with the fiscal purse strings, which should all things being equal be good for German growth. China could get better rather than worse, and that would be good for demand of European goods. But also you do have this possibility of something going right rather than wrong in Ukraine. So I think there's a bunch of upside risks for European stocks there that are not currently very well priced.

18:22And I think just the America first, American exceptionalism agenda is so overwhelming that actually a lot of the kind of counterpoints from Europe are just getting totally obliterated. The best time to own any asset is not at dawn when the sun comes up. It's one minute after midnight, meaning everything looks perfectly awful in every way. And then it goes to almost everything is perfectly awful. It's just the tiniest spark appears somewhere on the horizon. And that's when you see the biggest move in any asset class is when you go from completely dark to almost completely dark. You heard it here first by France.

19:11By France. You heard it here first. So if you do feel like the U.S. is in a bubble for whatever reason, maybe you think there's an inflation shock coming, maybe you think there's a growth shock coming, maybe you think there's some sort of tech AI crap out coming. There are alternatives, right? you know, we're not kind of here to give you like investment advice at all. But depending on the type of shock, it might be it might be bonds, it might be cash. But mate, there are other places in the world than the US. Not sure if you guys are aware. And regimes change. Regimes change. Markets. We're in a very USC investment regime.

19:42We don't know when it's going to stop. It's been great to be owning US assets, big cap stocks, especially, but things change. And as the last three weeks have shown regimes, like government regimes change very fast. And that can change the market too. Hell yeah. That is a whole thing. I would love to do more questions from readers, but we are absolutely bang out of time, so we are going to be back in a sec with Long Short.

20:14Okay, it's time for Long Short, that part of the show where we go long, a thing we love, or short, a thing we hate. But just to be annoying i'm gonna make you guys do it differently and ask what are your new year's resolutions you haven't even thought of this i have one no i i 100 have one go on i'm gonna try to concentrate in the new year i feel like i i have incredibly bad internet social media father of teenagers New Yorker scatterbrain. And I just want to every day take a little time to just try to focus on whatever it is I'm doing, whether it's walking down the street or making a cup of coffee or writing an unhedged column or doing a podcast.

21:05I want to try to pay some attention to my life before it ends. Just don't start talking about being present in the moment and wellness. No, no, I will never stoop to using that kind of language. But, you know, it's as simple as just trying to concentrate a little bit in 2025. Aidan, how are you going to be a better person in 2025? Well, now I'm going to hit Rob on the head all year with various, you know, psychological and new wave meditation. My resolution or one of my resolutions for 2025 is to read more female authors. I am very often in the dead man trap where I read a lot of old dead men and what they have written.

21:45I just did a big Philip Roth binge. I just bought Proust but I'm just going to try to read actual female authors and expand my mind from these old dead white men I can help you out with that I went through a phase where I did an entire summer where I didn't read any men and I didn't even do it on purpose and yeah, ladies write books too it's a good point so even though this is my question and I posed it and I sprang it on you I don't really have a New Year's resolution on my own but I am going to do my usual very, very boring thing which is dry January no booze in January Been plenty of booze in December.

22:18Do not need more booze in January. Correct. So I'm going to be very, very boring. Yeah, I'll be very boring in January. And yes, I can use that to interrupt your wellness when we speak later in the year. Guys, it's been a blast. We're going to have an excellent 2025. I can feel it in my bones. Hooray. Listeners, tune in. We'll be back in your ears pretty soon. Unhedged is produced by Jake Harper and edited by Brian Erstad. Our executive producer is Jacob Goldstein. We had additional help from Topher Forges. Cheryl Brumley is the FT's global head of audio. Special thanks to Laura Clark, Alistair Mackey, Greta Cohn and Natalie Seidler.

22:59FT premium subscribers can get the Unhedged newsletter for free. A 30-day free trial is available to everyone else. Just go to ft.com slash unhedged offer. I'm Katie Martin. Thanks for listening.

23:22We'll be right back.