Everyone gets it.
QE, the price-insensitive bid from SWFs, debt-funded buybacks, and passive investing are all the same damn thing. It’s all one trade. It’s “Heisenberg’s Wave Paradox.”
No one can distinguish between making a good decision and a decision turning out good by virtue of your having made it. When everyone falls into that trap, it’s no longer possible to distinguish between riding the proverbial wave and creating the wave you’re riding.
This is a self-fulfilling prophecy – a perpetual motion machine. And the longer it goes on, the more people it captures until finally, everyone is (unwittingly) in on it.
We – and plenty of others – have noted that active management has begun to throw in the towel when it comes to besting passive. How do you outperform a benchmark that’s being driven by a perpetual motion machine? You can’t. And especially not when you’re playing from behind by virtue of the fact that the people replicating that benchmark are paying as little as 5bps in fees to participate.
And so, what do active managers do? Well, they just stop trading. They become passive investing vehicles themselves.
In what is one of the clearest explanations of this dynamic to date, Wells Fargo is out with a note aptly entitled “Passive Is The New QE: The Buy-Side Is On A Seller’s Strike.” Not to put too fine a point on it, but this note is hilariously blunt. Consider the executive summary:
First and foremost, we believe the ripple effects resulting from the aggressive move towards Passive equity investing…
…are beginning to resemble the footprint left by QE.
With QE, the Fed removed from circulation a material part of the Treasury market (by our calculations over 20% at the peak). The decreased Treasury ‘float’ as well as the reduction in the amount of natural sellers (with the reduced float) coincided with the general upward trend in Treasury prices or lower yields. Read: Scarcity value and Fed front running.
- Currently, the shift to Passive is coinciding with ever higher equity prices with many equity indices trading at or close to all-time highs. As QE seemed to exaggerate trends in the fixed income markets, so it appears that Passive equity flows are exaggerating stock movements.
- Recently we’ve observed consistent net inflows to Passive Equity funds, which have morphed into a type of Black Hole. Money goes in and stocks never come out (as least for now).
It would be difficult to put it any more concisely than that. But it actually gets better.
“Clients have said repeatedly that any time they’ve sold or tried to reposition in the last 3, 6, or 12 months, they’ve come to regret it,” Wells goes on to write. So guess what active has decided to do? They’ve gone on a “seller’s strike.” To wit:
To fix this issue, they’ve decided to all together stop, or dramatically slow, their selling and it’s worked—relative performance continues to improve.
The positive results seem to have emboldened many to continue the Strike which in our belief has made inertia an increasingly powerful force in the capital markets.
So if they sell, they underperform. So they simply stop selling. But by not selling, they join the perpetual motion machine. That only makes that machine stronger and thereby makes it even more impossible for any one active manager to go against the grain and sell. The result: selling has become anathema. It’s a logical impossibility.
As Wells goes on to observe, “a cynic” might suggest that what active managers have now resorted to is hoarding increasingly scarce shares of attractive stocks and waiting for opportunistic moments to drive up the price. Read this:
Additionally, as Passive increases in market share, there are less natural sellers and consequently an even greater scarcity value (demanding a higher price for liquidity). One could argue that Active is providing adverse selection to Passive. Active may be more willing to provide liquidity for their less attractive holdings and to a degree force prices higher for their more attractive holdings.
A cynic would read this as an arb-ing or a picking off the uniformed and time-sensitive Passive equity flow.
These are your markets on passive investing, folks. I hope you’re happy with yourselves.
"Passive Is The New QE" pic.twitter.com/7kN4V9XIpO
— Walter White (@heisenbergrpt) October 31, 2017