Guess what? Retail investors are fading the tech rally without even realizing it. Or so says JPMorgan.
Part and parcel of the idea that this market increasingly resembles what Howard Marks has variously described as a “perpetual motion machine” is the idea that passive flows into cap-weighted indexes are creating a self-fulfilling prophecy. Here’s Marks (more here):
The large positions occupied by the top recent performers — with their swollen market caps — mean that as ETFs attract capital, they have to buy large amounts of these stocks, further fueling their rise. Thus, in the current up-cycle, over-weighted, liquid, large-cap stocks have benefitted from forced buying on the part of passive vehicles, which don’t have the option to refrain from buying a stock just because its overpriced.
Like the tech stocks in 2000, this seeming perpetual motion machine is unlikely to work forever. If funds ever flow out of equities and thus ETFs, what has been disproportionately bought will have to be disproportionately sold. It’s not clear where index funds and ETFs will find buyers for their over-weighted, highly appreciated holdings if they have to sell in a crunch. In this way, appreciation that was driven by passive buying is likely to eventually turn out to be rotational, not perpetual.
Earlier this year, Goldman made some waves by noting that the outperformance of a handful of names is increasingly making those names synonymous with things like low vol. and (by definition) momentum. That suggests the best performing sectors (e.g. info tech) will end up benefiting from the proliferation of smart beta products. The result: a never-ending bid for the winners that feeds on itself. Hence the “perpetual motion machine” characterization.
This is creating a truly hilarious scenario where, in order to keep from underperforming, active managers have to effectively go on what Wells Fargo recently described as a “seller’s strike” that involves simply buying the same high-flying names and overweighting the same sectors and simply riding the wave; a wave which, by virtue of that seller’s strike, becomes larger still. It’s Heisenberg’s “wave paradox.” Here’s Wells:
The positive results seem to have emboldened many [active managers] to continue the Strike which in our belief has made inertia an increasingly powerful force in the capital markets.
All of that to introduce a pretty amusing bit from JPMorgan which speaks to the second sentence in this post. As the bank writes, “the tech sector underperformance over the past two weeks is raising questions about position overextension in the tech sector and growth stocks more broadly.” That is of course a reference to the rotation out of tech and growth and into value that gathered steam on November 29 amid factor-based flows and optimism around the tax plan which isn’t seen as particularly beneficial for info tech.
That, in turn, raises questions about whether tech is vulnerable and JPMorgan thinks that part of that debate revolves around who was behind the rally in the first place. Surprisingly, the bank doesn’t think retail investors are to “blame”:
By looking at mutual fund and ETF flows, it does not appear that retail investors are responsible for this year’s rally in tech or growth stocks.
This is based on growth mutual fund outflows outpacing value outflows and on equity ETF inflows being roughly equal for value and growth.
So who’s behind the outperformance of tech? Well, according to JPM, institutional investors:
It is clear from Figure 6 that all tech proxies have seen a reduction in the short interest over the past few years closing their gap with the overall equity market. In fact, Figure 6 suggests that the short interest gap between S&P500 and either FANG or FANG+ approached that of the S&P500 only recently. At face value, this implies that leveraged investors such as hedge funds have been steadily covering shorts on large tech companies and only recently their short interest converged to that of the S&P500. In other words, this short covering has neutralized previous underweights rather than making these leveraged institutional investors very overweight.
I guess. Although hedge funds are pretty overweight in these names and in info tech more generally as Goldman points out every quarter.
Anyway, here’s the punchline:
We get a similar picture by looking at tech equity ETFs. One simple metric to assess tech exposure in the ETF space is to look at the share of tech equity ETFs as % of total equity ETFs. Admittedly, this share is a function of both market performance and fund flows. An elevated tech share would be indicative of elevated tech exposure and vice versa. Fund shares by themselves tell us little about investor positioning if one fails to take into account the changing tech share in global equity indices. To adjust for this, we divide the tech share in the ETF universe by the tech share in equity indices. This ratio is shown in Figure 5. It shows that ETF inventors, the majority of which are likely to be retail, have been struggling to keep up with the rise of the tech sector since 2014. As a result, ETF investors have been fading rather than amplifying the tech rally since 2014 including this year. In fact, Figure 5 suggests that ETF investors have become progressively more underweight the tech sector.
I’ve got a number of questions about how that chart was constructed, but my skepticism notwithstanding, this is an amusing anecdote considering the prevailing narrative.
I guess the takeaway for my retail audience is this: buy more tech! Or, in the words of one popular pundit: “just buy the damn robots.”
