The unintended consequences of the shift to passive investing

Look up any modern guide to investing and the common wisdom is unequivocal: stick your money in a passive fund that’s low cost and no frills, and you’ll get exposure to the broad stock market which has a track record of strong long-term performance.

That marketing spiel has enjoyed unquestionable success, even if judged purely on headlines: a quick Google search of “Global Passive AUM” throws up an interesting set of headlines and dates. Don’t take the headline numbers seriously – the underlying measures vary drastically. The key is to understand the narrative that is driving the structural move.

3 Feb 2017 - “Passive reaches $6tn of global assets - Funds Europe”

31 Oct 2017 - “Global passive assets to hit $37 trillion by 2025, reports PwC”

30 Oct 2018 - “Passive giants take global AUM to $95trn” - Expert Investor”

17 May 2019 - “History Made: US Passive AUM Matches Active For First Time”

Is active management as we know it well and truly dead?

It's possible that the answer is yes. At least in the world of equities, and in the form we’re most familiar with – stock picking. Here’s the exam question:

An active manager solves for price: what is the price that reflects the expected future value of the instrument in question? At the wrong price, an active manager can decide to set quantity to zero and do nothing. In contrast, a passive fund solves for quantity: for a given amount of inflows, it must trade a specific quantity of stock, whatever the price may be. What happens if a passive tracker needs to set its asking price to infinity to fill its trade ticket? Or to zero?

We’ll be the first to tell prospective investors that the best way to track the benchmark index is to buy an ETF. If the aim is to simply “match” the benchmark, for better or for worse, we’d agree wholeheartedly with the conclusions of Sharpe’s seminal 1991 piece “The Arithmetic of Active Management”. Yet as we spelt out in our previous note on The Cult of Passive Investment, making the active choice to go passive also means taking the full risk of the market as determined by the tracking fund’s parameters, and possibly a bit more if things go wrong.

The rise of passive investment is often hailed as a victory for democratising investing. The simplicity of a product that simply “invests in the market benchmark” is appealing, and, with the cost of doing so being minimal, is touted as long overdue rebalancing in favour of the masses. Yet as we head into 2020, it is equally evident that the rise of passive has set in motion changes in market structure that have yet to be properly understood and priced.

Not all is well.

Let’s start by putting things in context, in order to visualise how far the passive story has gone.

According to BIS data in its March 2018 note on “The implications of passive investing for securities markets”, passive’s share of global AUM sat at around 20% as of June 2017. Cumulative flows tell the story of (almost) every active equity manager’s life: outflows from active, inflows to passive. So much so that the biggest active managers have become the biggest passive managers as their own business model has shifted. These trends are expected to continue, at least for now.

A more recent report by BCG “Will these ‘20s roar?” puts their forecast of global Passive AUM in 2023 at 23%. More bad news for Active managers, and more good news for Passive funds.

Exactly how bad is the situation for Active managers? 6 consecutive quarters of global outflows, according to the FT, of which about 61% came out of Equity funds:

Is that such a bad thing? After all, if we agree with Sharpe’s arithmetic on active management, at the very best only a small percentage of active managers make money, so the rest don’t really need to exist. No one will be sad that they’re gone.

It’s never straightforward.

This view ignores some critical issues, not least the idea that passive funds – rather than being “passive” as their name suggests – are actually now impacting the construction and composition of the indices they were built to track.

To call on the Quantum Mechanics analogies we love to use, these indices, originally conceived as observation instruments for gauging the health of the overall market they represent, have now become entangled with the supposedly passive trackers that track them: indices determine the decisions of trackers, but trackers’ holdings also influences the composition of indices.

From the same BIS report we see empirical evidence that the inclusion of a stock into an index, in this case the S&P 500, significantly increases its correlation with the index, along with other benefits like improved trading volume and lower bid/ask spreads:

2018 was the first time ever that there was a day where every single one of the 500 stocks in the S&P500 moved in the same direction. What's even more extraordinary is that it happened thrice that year. This underscores the growing correlations between stocks: liquidity and the (ir)relevance of fundamentals.

Credit for much of the following insights goes to Mike Green of Thiel Macro, whom we believe cuts to the heart of the reasons why markets behave like they do today. His interview on RealVision, “The Perils of Passive Indexation” is a must-watch.

The first issue Green raises is liquidity. This sounds counterintuitive, given just two paragraphs ago we showed a chart showing that index inclusion, thanks to the action of ETFs and passive funds, leads to higher trading volumes and lower bid-ask spreads, a result of higher liquidity. But consider the fundamental difference between a passive manager and an active manager.

An active manager, ourselves included, undertakes comprehensive research work in order to identify mispricing in the market. The result of all our work, correct or otherwise, is an idea of where the price should be. We don’t believe in target prices specified to 2 decimal places, but we believe in the value of having a variety of differing opinions in the marketplace.

Why is this important? Because a variety of opinions on what any instrument is worth represents a manager’s willingness to deploy capital at various prices. For example, with Apple trading at around $280 today, if we believed that it was worth $400 a share, we would be buyers of the stock at this price, supplying liquidity of cash at current levels all the way until $400. Likewise with Tesla trading at just over $400, if we believed that it was worth less, we would be sellers of the stock at this price, supplying liquidity of stock at the current levels. The variety of opinions regarding valuations, and the tendency for an active manager to exercise discretion to buy when the price is “too low” and sell when the price is “too high” leads to the provision of liquidity in the market – not just at the current price, but at potentially all prices.

The presence of active managers and their differing opinions on price across a wide spectrum gives the market depth: demand and supply are present across a large range of prices, rather than just at the current price.

In contrast, a passive tracker has a much simpler “mandate”: buy when the fund receives an inflow, and buy in the percentage weights of the underlying benchmark; sell when the fund suffers an outflow, and sell in the percentage weights of the underlying benchmark. Price has no place in the decision making process, only capital flows in and out of the fund. There is no room to “make a deal” with a passive fund, no matter how attractive the deal may be. It’s a machine that buys and sells as a function of flow.

In other words, a market dominated by passive funds will be much more shallow: liquidity is present at the current price as long as flows are stable. Outside of the current price, the presence of bids and offers dwindles quickly, leading to greater risks of stocks being locked limit up/down and liquidity disappearing once price fluctuations become bigger.

Herein lies the risk: so far, as we’ve seen in the above data, the majority of assets in the market are still actively managed. But that dynamic is very close to tipping point, especially in the US.

As of Aug 2018, according to this report from the Boston Fed, the balance between active and passive stood at just under 40%:

That balance is now much closer to 50-50, as this data from Morningstar, cited by Bloomberg, demonstrates:

This trend in the US market is without a doubt a harbinger of what is to come for most major equity markets around the world.

Why is this a problem? Because when the market moves from trying to find the right value for an asset (active managers) to finding the right quantity to trade corresponding to a given in/out cashflow (passive funds), price becomes irrelevant. Flow is everything.

An active manager solves for price: what is the price that reflects the expected future value of the instrument in question? At the wrong price, an active manager can decide to set quantity to zero and do nothing.

In contrast, a passive fund solves for quantity: for a given dollar amount of inflows/outflows, it must buy/sell a specific quantity and proportion of stocks, whatever the price may be. What happens if a passive tracker needs to set an infinitely high price to fill its buy ticket? Or to zero for its sell tickets?

Fortunately the latter has not happened yet. At least not until the flows stop.

As argued by Anadu et al in their paper published by the Boston Fed (the same one referenced above), not only is there evidence presented that:

“... investor flows for passive MFs are less performance-sensitive than those of active funds, so passive mutual funds appear to be less likely than active funds to suffer large redemptions following poor returns.”

the authors also note that (emphasis ours):

“Unlike MFs (Mutual Funds), which offer cash to redeeming investors, ETF redemptions typically involve in-kind exchanges of the ETF’s shares for “baskets” of the securities that make up the fund. As of March 2018, ETFs that redeemed exclusively in-kind accounted for 92 percent of ETF assets. By offering securities for securities, ETFs minimize liquidity transformation; redemptions from the ETF typically do not diminish its liquidity or increase incentives for other investors to redeem shares. Hence, as long as the largely passive ETF sector is dominated by funds that redeem in-kind, a shift of assets from MFs to ETFs reduces the likelihood that large-scale redemptions would force funds to engage in destabilizing fire sales. That said, one caveat to this positive outlook is that ETFs investing in less-liquid asset classes have grown rapidly in recent years and are more likely than other ETFs to use cash redemptions; further expansion of ETFs that redeem exclusively in cash could erode the stability-enhancing effects of ETF growth.”

In other words: given the great run that ETFs have had, no one’s really complained about poor performance yet. But even if things go awry in markets, and there’s no one around to sell your ETF unit to, don’t worry about crashing prices, it’s not a problem as long as you’re happy to receive stock instead of cash.

We don’t question the veracity of the evidence presented, but we do think these conclusions need to be put into the context of the past 20 years: the bulk of the data set used in this study only began in 2000, but 20 years is a mere blip in the history of markets.

This is what happens when you solve for quantity, not price.

Apart from liquidity, the other major issue is the growing irrelevance of fundamentals.

When price no longer matters, fundamentals start to matter less, much to the chagrin of analysts and portfolio managers. The number of situations we and many other managers have been in where “high conviction” calls go wrong, not because of any fundamental problem with the companies, but simply because of “the market” are a testament to that.

No wonder then that traditional benchmarked managers, especially long-only managers, are finding it hard to perform. All they can do is try to be different in order to beat the benchmark. ESG anyone?

Credit again to Mike Green for flagging this specific example: VF Corp, a sports apparel company (better known for its brands including Timberland, The North Face and Vans), that is the “median” company in the S&P 500 index. VFC’s average earnings per share has been largely flat for the past 8 years, but the stock price has risen from c. $20 at the beginning of 2011 to $95 currently, seemingly by virtue of just “being an index stock”.

The Emerging Market world is also full of similar examples. Take for example Indocement, the #2 cement producer in Indonesia. Its full-year earnings in local currency as of the end of 2018 is at a third of what it was in 2011, but its stock price is currently about 25% higher than it was at the time, seeing its 12m trailing EV/EBITDA multiple rocket from around 15x in 2011 to 66x in Dec 2018. Why? Primarily because it is a top 10 holding of the MSCI Indonesia index and a top 15 holding of the local LQ45 liquidity index, both benchmarks that local and regional funds’ performance is measured against, making this a “must own” stock for reasons unrelated to its earnings potential.

Dislocations like these are abundant across today’s equity markets, and where managers used to be able to sit tight in anticipation of the market ultimately reflecting the fundamental reality, it is becoming increasingly difficult to do so.

For now, fundamentals still matter. We still actively seek these dislocations out but we also acknowledge that they can only be corrected if the flows happen to coincide with our theses - that is why our approach and process encompasses both the Big Play and the Small Play.

But this is changing. As pointed out by Chris Cole of Artemis Capital Management’s in his July 2018 investor letter:

“When the market is dominated by passive players, prices are driven by flows rather than fundamentals (see right tail of blue line). In my simulation, the excess alpha available to active participants peaks when passive investors comprise 42% of the market, then drops dramatically the more the passive share increases. When passive participants control 60%+ of the market, the simulation becomes increasingly unstable, subject to wild trends, extreme volatility, and negative alpha. In the real world, because the ratio between active to passive is not constant, the instability threshold will occur at a much lower threshold as investors shift their preference to passive in real-time.”
Christopher Cole, Artemis Capital Management, Letter to Investors July 2018

These changes also have knock-on effects on the broader industry: as more allocations move to passive instruments and active managers shut down, the demand for company research and qualitative input dries out, leading to the sell-side deciding to shed its research analysts in tandem. The remaining active managers then have to build up their own research capabilities in-house, adding to their cost base, in the face of falling management fee levels, further challenging the sustainability of their business models.

So what happens from here?

For long-only managers whose performance is measured against a benchmark, this is terrible news. The reality is that equity markets have been permanently changed, and the odds of markets going back to the way they were are not high.

The need to outperform a benchmark, coupled with the change in market dynamics, makes it immensely difficult for a traditional long-only mutual fund to do its job. Cutting management fees on mutual funds only postpones the day of reckoning. ETFs and passive trackers have supplanted their role as a provider of broad-based access to markets, at a much lower cost. But the low cost comes at a risk: of unintended consequences for market structure and behaviour, and of a lack of downside protection when things inadvertently go awry.

If pure, unadulterated market exposure (or any multiple of that, from -3x to 0.5x to 3x) is what an investor is looking for, this isn’t a problem. The past decade, particularly in the US, has been tremendous for equity investors. Who knows what the next decade holds?

But if it is not similar to what we have seen, we could be in for a time where even free passive investments may not be so appealing. For investors who want to preserve their capital, they have two possible options left:

Keep it all in cash;
Invest it with managers whose mandates are to preserve capital, limit downside and make a decent compounded return over time – regardless of what the market does.

Some money you just can’t afford to lose, no matter how cheap the fees may be.