The Massive Passive Elephant in the Room

In a world of low interest rates and anemic growth, everyone wants to minimise their wealth management costs. In such a climate, index-linked funds have become increasingly popular as minimal human involvement in decision-making, naturally results in lower fees. This “passive investment” strategy is essentially automation of the wealth management industry, and therefore cuts out the wages and bonuses normally required to reward talent in “actively” managed funds.

A report by wealth advisers Providence points out that the increased dominance of passive investing has resulted in a handful of funds controlling a large amount of capital. Providence cited data showing that the top 10 managers accounted for 57 per cent of the Australian funds management industry. Among the biggest investors are the largely passive funds such as Vanguard, State Street and Blackrock, alongside local giants AMP, Colonial and IFM Investors.

For those that aren’t familiar with the terminology, the strategy is simple. Various stock market indices exist to gauge the health of the market. Such an index contains a sample-size list of the most popularly traded stocks, weighted to match their contribution to the market. The list is reviewed regularly to remove stocks that have fallen out of favour and introduce new stocks that are trending up. An index-linked fund simply buys the stocks currently in the list and sells what is taken off, with little to no human involvement.

As this style of investment has gained popularity, in a rising market everybody wins. Wealth that continues to buy into this small set of stocks creates an upward price movement. To illustrate how this effect can impact just about any asset class, I’ll use a simple example. Start with buying a kilogram of gold. Convince two friends to each buy a kilogram of gold. If they do so and recursively go on to tell another two friends each to do the same, the amount of gold buyers multiplies quickly and eventually overcomes market supply. Assuming I don’t sell and none of my friends of friends of friends sells, the market price of gold will continue to rise as long as new buyers can be convinced to participate in the strategy. While gold does not actually generate growth/profit/returns, the increase in price alone might be able to convince more people to participate in the strategy. This is the same positive feedback loop dynamic that can underlie the inflation of asset bubbles.

Problems only manifest when the market turns. Passive investment is the embodiment of pure “herd mentality”. When the herd moves in a positive direction, everyone benefits. There is protection in numbers; numbers that support the stock market index valuations behind everyone’s collaborative wealth generation plan. Nobody wants to cross the herd, and there is no justification to, when the pack appears to be doing well. However, if you trigger a crisis, then herd mentality begins to work against you. Panic ensues and people start to sell, and the whole pack moves against the strategy. Stocks on the index will undergo a vicious cycle of immense waves of selling. Their price declines lead to more investors crystalising loses and more redemptions further sell down all the stocks on the index linked to that particular fund. Any affected stocks can then impact the performance of other indices they are included in. Index linked funds can create a network of interlinked assets and funds that can cause selling panic to quickly traverse between regions.

The firm reviewed its international fund managers to measure how they performed during periods of significant market declines. It found that in the last five market corrections, the actively managed global funds it selected had fallen by 8 per cent compared with the 14 per cent index decline over the same period.

Australia is especially vulnerable, as our market is heavily weighted towards a small number of dividend providing stocks. Any selling pressure would be concentrated on a handful of unfortunate stocks already operating in sectors facing the strongest headwinds in the Australia economy.

Australia’s sharemarket is far too concentrated in banks and miners, which make up 62 per cent of the index, three times more than the global index exposure. Meanwhile, the top 10 stocks in the Australian index make up 47 per cent of the index, compared with 11 per cent globally.

Now would be a good time to take stock of your investments and make sure that your wealth is both diversified internationally and not tied to the fate of the herd.


Australian Property: The New Paradigm

Abstract: A summary of how an exaggeration of Chinese money has been used to accelerate the growth of bubbles across global markets. New wealth creates economic distortions as less thought and experience is applied in negotiating prices when allocating investments. Token evidence of this can be used to convince other investors around the world to also enter the market looking for quick gains. The effect is compounded by the youth and inexperience of both China’s central government and their domestic finance & wealth management industry. A clear problem as this industry is the key to supporting China’s aging population. As China’s finance industry matures it is likely that money will move from overpriced assets into more productive endeavors.


I should begin by saying that this is a pure opinion piece. Nothing written here constitutes financial advice. I do not profess to have the investigative prowess of a journalist nor the professional credentials of an economist. I’m simply an avid observer and casual writer.

I recommend starting with the opening pieces; The Politics and The Welfare and The Financials.

The New Paradigm

Studies into market bubbles break a bubble’s lifecycle into several stages. The last pre-crisis stage is often referred to as the New Paradigm. At this point, the market has reached new dizzying heights that even exaggerated statistics and reports fail to rationalise the price. At this point, any further growth is supported by the sheer will power of those that wish to get rich. The New Paradigm is defined as a tautology that justifies future price growth and is conveniently vague on facts, yet difficult to disprove. The significant evidence required to disprove the tautology is often unavailable due to incomplete data, easily manipulated statistics or a complete lack of reporting. It’s not hard to guess what has been a commonly used tautology in recent years. You probably have heard it repeated many times around the world already; “the Chinese will buy it”.

The interesting aspect of this particular New Paradigm is that it has been used in not just one bubble, but several which are all at varying stages of their lifecycle. The spot price of uranium peaked at about $300/pound on the back of assumptions that China’s unquenchable thirst for energy would drive it to build dozens of nuclear power plants. The inconvenient truth is that nuclear power plants can take up to a decade to construct. At the time of writing, the spot price has been languishing at about $36/pound for almost half a decade. With gold being a cultural icon and traditional store of wealth in China and India, speculators pushed the price of gold above $1900/ounce before dropping to the current price around $1100. Earlier this year, the price of iron ore and coal both peaked at $140/ton and $112/ton respectively. Now they are barely clinging to $56/ton and $49/ton after bouncing off record lows. Further price declines are anticipated as all the major miners are still ramping up production previously planned and funded on the expectation of continued Chinese demand. Their analysts lazily predicted that China would reach the perfectly round estimate of 1 billion tons of annual steel output, when reality peaked at approximately 700 million. Cryptocurrencies like bitcoin also saw huge rises and falls from speculation on Chinese involvement before their government clamped down on the cryptocurrency.

As bubbles are only defined the moment they pop, it would be premature to infer that any market “dominated” by the Chinese is suffering from inflated values. That said, the Australian housing market continues to chart new heights on the assumption that Chinese buyers and developers will continue to bring their millions over. This is despite Chinese government restrictions on capital outflows, a corruption crackdown in progress, and Australian government rules limiting foreign property purchases.

The Chinese are equally victims of recent bubbles. If they are buying in at the top end of the market then they are likely to suffer the greatest loses in a correction. As the largest consumers of commodities like iron ore, coal and copper, they have been paying inflated prices on these resources for many years now. Cultural misunderstandings like numerology are being propagated to further asset price growth. Xenophobic sentiments brew in those priced out, when all the blame is misdirected at the manipulated instead of the manipulators. However, even the manipulated must be responsible for their actions. While the New Paradigm is often far from reality, there needs to be just enough truth to it to make it believable.

The Asian generations of the last few decades are an inspiring tribute to how perseverance and hard work produce success if given the right opportunity. Stories of lonely pig farmers who go on to make millions, former soldiers who rise up the ranks of the business elite, and glass polishers who set out on their own to become the dominant global force in their trade. These are economic fairy tales the world hasn’t seen in decades. Despite all they have achieved, it would be a lot to expect them to revolutionise their respective industries, and also learn to manage their newfound wealth in a responsible way. Unlike established wealth, these newly minted millionaires cannot look to family and friends for guidance or example. In my own experience, my parents do not trust or understand the stock market. Their generation created wealth through trading in tangible goods. Being of Chinese heritage, my grandparents set aside and labelled small chunks of gold as our inheritance. A concept that seemed odd, awkward and somewhat inconvenient when a nugget named Kevin was first revealed to me. A transition that spanned three generations in my family is unfolding in a country with over a billion people who have only embraced capitalism in the last 35 years!

This is not a problem unique to emerging economies. You can see the same underdeveloped or misdirected use of fortunes in young Silicon Valley entrepreneurs, mining barons of Australia and the oil sheiks of the Middle East. It’s no surprise that each of these regions has exhibited a hot property market. Billionaires are economic distortions. Bill Gates is the richest person in the world and he built most of his early wealth on inflated profit margins on hundred dollar copies of Windows software. Too preoccupied with revolutionising the home personal computer market, Mr Gates conveniently neglected to reinvent the pricing model in a new world of 5 cents compact disc manufacturing & online distribution. The most popular version of Windows was released over 20 years ago, and it’s only in the last 5 years that Google have fixed this pricing problem by releasing the free Android OS. More recently, the billion dollar valuations of sharing economy startup giants are supported by revolutionary business models that sidestep regulation and promote tax evasion. Tax legislation in many countries has not adapted to technology’s ability to create multi-national companies with tiny local footprints that turn over billions of dollars of revenue. Locally, Australian miners grew immensely rich due to government mining royalties that failed to track commodity prices, thus diverting the wealth of the nation into the pockets of the lucky few. When someone holds wealth that they cannot reasonably spend in one lifetime, they make irresponsible decisions. Asia is minting new billionaires at a record pace and the result is that their newfound wealth is contributing to the creation of market distortions across an increasingly interconnected global economy.

The problem is exacerbated in China by the fact that the Chinese government heavily restricts cash flows in and out of the country. Much of the new wealth generated in the country is forced to rely on an equally fledgling wealth management industry within China. A huge shadow banking system operates outside of government regulation. Their stock exchange is still dominated by novice retail investors trading penny stocks for a gamble on capital gain. The small role the Chinese stock market plays in the economy is highlighted by the low proportion of market stabilising institutional investors and the relatively low 11% of household wealth invested in stocks. Compare this with the only other economy larger than China’s; around 30% of US household wealth is invested in stocks. Meanwhile international investment houses are restricted in what Chinese stocks they can invest in and by how much. The wealth that does escape the country through dark channels is too questionable in origin to enter highly regulated wealth management institutions who are obligated to report suspicious funds, and ends up inflating asset prices in destination countries.

The inexperience of China’s financial system and governing body is apparent in their government’s initial reaction to their recent share market correction. The Chinese leadership intervened directly to try to prevent short selling and publicly ordered various bodies to begin buying shares to support prices.  The initial domestic mum & dad investor panic quickly into institutional and foreign investor panic. With a lot of professional & institutional investors, removing access to investment tools like short selling breaks their risk management and hedging models. This increases the risks on their investment thus obligating them to sell the shares they do hold to move their client’s funds into stable cash positions until they can adjust their models to the new operating environment. Government intervention and tampering with market dynamics also adds to ongoing media coverage, further propagating the panic across the globe. Investor panic is a monthly occurrence in world markets, panic in a nation’s leadership is a rarer, more concerning event. The swift co-ordinated effort by many government controlled institutions does lead me to think that there is a greater plan in play and that they simply miscalculated how quickly the market would rise and how soon the next correction would take place. It is evident that they are positioning multiple large investment institutions like the 5 billion dollar state pension fund into a market stabilisation role (much like in the West). This correction should be treated as an opportunity to educate the many retail investor on the merits of understanding fundamentals and on the benefits of prioritising dividends on blue chip stocks over capital gains on penny stocks. In the developed world, stock markets are used heavily in growing and managing retirement savings. China is facing a huge demographic problem of an aging Chinese population accelerated by decades of the One-Child Policy. Their stock market is going to have to play a pivotal role in supporting the next generation of retirees.

It’s a complex problem that will take time to untangle. There are good reasons why there is a lot of protectionism around the Chinese financial industry. Like most developing nations, it seeks to preserve the country’s resources and opportunities to benefit their people, by limiting access to foreign investors. Throughout much of Indonesia’s development, the government has forced foreign nationals to create joint ventures with local entities to foster knowledge & technological transfer and ensure some of the profits are returned to the people. In a similar fashion, the Chinese government would rather see their millionaires support the development of a home grown finance and wealth industry. Understandable in light of the reputational loss experienced by Wall Street when the global financial crisis exposed the rampant greed endemic to finance corporate culture. The Chinese government also strongly promoted share market investment prior to the recent market rise as a way to ensure their citizens will front run the huge international investment that would come when the MSCI includes China A-shares in its benchmark indices. When this global economic milestone is reached, hundreds of index linked funds will be forced to invest in the Chinese stock market to keep pace with the MSCI index. The flood of foreign capital will propel the wealth of those already invested. In a country with a track record for copying the rest of the world, it is only a matter of time before a Chinese Warren Buffett, Ray Dalio or Kerr Neilson emerges. It’s no coincidence that Mr Neilson was an early investor in China and is now doubling down on his highly profitable early bets made a decade ago. While the Chinese government’s measures are well-meaning, they have produced unforeseen results with global consequences. Co-ordinating more than a billion people to orchestrate the creation of an economic powerhouse to rival the United States is no mean feat.

Mistakes do eventually get corrected, and while many lament China’s leaders’ iron fist rule, I can’t deny that their ruling party’s unquestionable authority has led China to sidestep or resolve every type of catastrophic economic blunder made by many other developing nations. It would appear that Xi Jinping’s reforms are far from being thrown off track. The New Paradigm won’t hold forever. As China’s finance system liberalises and matures, the market distortions will unravel and soon enough, the Chinese will be selling.

Read on in the next section: The Investors.

Thank you for reading. If you would like me to write more articles on this topic, please “like” this post, or feel free to start a discussion or make suggestions in the comments section below.

Further Reading:

Australian Property: The Politics

Abstract: A look into how Australian politicians have displayed favouritism towards the banking and real estate industry in Australia over the last decade. This legislative support has allowed large sums of speculative money from foreign sources and superannuation savings to flow into an already overpriced housing market.


I probably should have started this post a long time ago, but at the time I believed more strongly in the world order self-correcting. The Australian housing market has had an incredible run and unlike many of the articles floating around these days, this is not an impending doom and gloom piece. After many years of failure, I have since given up on predicting booms and busts. Since then I have come to the conclusion that money draws smart people and smart people can figure out how to keep making money and so the cycle continues, until the day it somehow stops. Every time the housing boom has shown weakness, these geniuses and master manipulators have unlocked a new source of money to further fuel the good times. This series of posts is more a recollection of the impressive sequence of events that have brought us to this point.

I should begin by saying that this is a pure opinion piece. Nothing written here constitutes financial advice. I do not profess to have the investigative prowess of a journalist nor the professional credentials of an economist. I’m simply an avid observer and casual writer.

The Politics

I’ve lived briefly in Indonesia and can still remember observing the influence of public sector corruption. This was during the Suharto era when Indonesia was the poster child for developing world corruption. I would spend one day in the propaganda driven reality distortion bubble, the next looking in from the Western world of free-speech. Many people think that a developed nation with an educated middle class is less susceptible to the lure of corruption, but that’s not true. The corrupt are simply better educated, and the corruption more developed.

Back during the Rudd vs Gillard turmoil, the media made mention of the “faceless men” who supposedly cast their influence over Australian politics from the shadows. Of course these faceless men would also be nameless. None in the media was capable of printing a name or delving into the topic to any serious depth. Some pointed blame towards the mining industry as the mining tax was a very contentious issue at the time. However as Australia’s freshly minted “new rich”, personalities like Gina Rinehart, Andrew Forrest, Clive Palmer and Nathan Tinkler are hardly inconspicuous. Gina tried unsuccessfully to buy influence over the media through large shareholdings in the Ten Network. Forrest made several futile attempts to provoke government intervention in the recent iron price rout via sound bites regularly picked up and ridiculed by the media. The mining industry’s biggest political wins are won through the Mineral Council of Australia’s paid advertising attacks that mobilise public sentiment to force the government’s hand. In contrast, these faceless men had to be part of Australia’s “old rich”; long established wealth that had worked its way into the fabric of Australia society over many generations to be able to apply direct pressure to the political community and selectively edit mainstream media. There are only two sectors in Australia that are bigger than mining; property and banking. Two very closely linked industries.

It was in the midst of the Global Financial Crisis of 2007 that the Rudd government announced some rather questionable yet highly effective economic stimuli. This was at a time when Australia was still riding happily on the back of Chinese growth with some of the highest mining commodity prices on record. The first was a bank deposit guarantee that greatly warped the risk equation for Australian banks, and lasted until 2012. Significantly longer than it was required (if at all). In guaranteeing the deposits of every account holder (under a $1 million threshold), the government provided free insurance to the banks. This boosted their international credit ratings and reduced the international wholesale cost of borrowing for Australian banks. Australia became one of the safest places to store money in period of global financial turmoil.

Next, in a bid to prop up a mildly correcting property market, the government introduced the First Home Owner Boost through which it granted $7000 to any property purchases for citizens purchasing their first home. In hind sight, the boost went directly to house prices which jumped about as much in the following months. In what could only be described as a stroke of genius, the government had spent a few thousand dollars on the needy to instantly raise the paper net worth of the other two thirds of the Australian population that owned property. With everyone feeling wealthier, consumerism ensued, a technical recession was avoided and the decade long economic boom continued uninterrupted.

Finally, less publicised is the fact that the Rudd government also loosened the foreign investment rules for residential property in 2009. Temporary residents could now purchase property without government preapproval and property developers could sell more that 50% of new residences to foreign investors. This was the first tentative step towards unleashing huge sums of international money into the Australian market.

The Gillard government that followed opened the flood gates in 2012 with the Significant Investor Visa. By rewarding large sums of foreign investment ($5 million) with a permanent residency visa, the government welcomed the rich, the corrupt and the highly leveraged. The wealthy could relocate their families to safe, politically stable, pollution free shores. The corrupt could flee with their ill-gotten gains. The opportunistic poor could draw money from shadow banking systems and start a new life in the lucky country.

If that wasn’t enough money to support the industry, the Gillard government also made changes to laws governing access to superannuation funds. Since 2003 laws around superannuation have allowed Self-Managed Super Funds (SMSFs) to allocate money to leveraged investments, but it was only around the time of the Julia Gillard government that the notion of SMSFs investing in property really took off. It’s up almost 60% since 2011. At that time, the government introduced a number of changes to superannuation in the Stronger Super reforms. One of them facilitated easier rollover from existing funds which I believe might have been a key requirement to allow Australians to unlock existing balances to use as the initial lump sum deposit on mortgages.

One other unusual initiative to support the property industry was the First Home Saver Account. A bank account designed to dangle government co-contributions as motivation for first home buyers to save their income towards a house deposit over several years. Not surprisingly, the adoption rate was appallingly low in a climate of urgency around double digit annual price increases.

It should also be noted that many politicians are also avid property investors. They have been known to collectively own an average of 2.4 properties, with one politician owning an impressive portfolio of 41 properties.

Read on in the next sections: The Welfare and The Financials and The New Paradigm.

Thank you for reading. If you would like me to write more articles on this topic, please “like” this post, or feel free to start a discussion or make suggestions in the comments section below.

Further Reading: