Proponents of passive investing are going to keep insisting that the epochal active-to-passive shift isn’t dangerous or otherwise prone to destabilizing markets. They’re going to take that narrative to the grave apparently.
That’s fine and as I’ve said on any number of occasions, it is unquestionably a positive development on net that there’s a universe of low-cost vehicles that allow investors to allocate efficiently and gain diversified exposure to broad asset classes without having to pay exorbitant fees to active managers who are almost guaranteed to underperform benchmarks over a long enough investment horizon.
That said, it is entirely unrealistic to assert that epochal shifts won’t be accompanied by unintended consequences. Inherent in the term “epochal” is the notion of sea change and sea changes do not often occur without unexpected side effects.
Last summer, in a controversial note, Howard Marks elaborated on how passive vehicles create what amounts to a “perpetual motion machine” that drives some stocks inexorably higher in a self-feeding loop that, if it ever reverses, could be destabilizing. Here’s the money quote:
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.
Over the past couple of months, flows into and out of passive vehicles have begun to approximate “hot money” – this dynamic was apparent in SPY in February (see here and here) and in QQQ during the recent tech rout.
With all of the above in mind, I wanted to draw your attention to the following brief excerpt from a new Goldman note which I present without further comment.
Heavily shorted names showing lower than expected volatility. For the first time in 6 years, the volatility of the S&P 500 has been greater than the volatility of the most shorted stocks. This suggests investors that short stocks (i.e. Hedge Funds) are not making big changes to their positions on a daily basis, while investors that trade at the index level are rapidly changing their positioning. We believe it is increasingly important for portfolio managers to know how much of their stocks are owned by passive funds as that appears to be one of the primary sources of the recent volatility. It may be less important than normal to track the institutional investor ownership of stocks as that is not the primary source of recent volatility.