Back in 2017, long before I stopped reading his memos, Howard Marks delivered one of the most incisive takes ever written on the extent to which US equities became a kind of perpetual motion machine in the post-financial crisis era.
I’m going to recycle some language from a yearsold article. When growth, tech and low vol all become synonymous, and when those classifications are used to construct a multitude of factor-based products, you end up with factor-crowding and a steady stream of money being channeled into the same names, sectors and styles. That created a self-fulfilling prophecy that manifested in the multi-year outperformance of secular growth shares and bond proxies.
The pandemic turbocharged things. The services and products offered by America’s tech giants already permeated nearly every facet of daily life. During the COVID lockdowns, digital life was the only kind of existence possible. Investors sought safety in the oligopoly whose businesses became synonymous with human existence.
The human experience was forced online and interactions were digitized by government decree (i.e., as a side effect of virus containment protocols). Tech companies became even more indispensable as the pandemic reinforced the trend towards a digitized, virtual world. That, in turn, reinforced a preexisting trend in markets.
The figure (above) is among the simplest ways to visualize the situation, but there are countless charts one could conjure.
Now, let’s put this in the context of Marks’s 2017 memo “There They Go Again… Again.”
“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,” he wrote, adding that “in the current up-cycle, over-weighted, liquid, large-cap stocks have benefitted from forced buying on the part of passive vehicles.”
In the same memo, he highlighted a simple, yet often overlooked, dynamic associated with smart-beta products. “Importantly, organizers wanting their ‘smart’ products to reach commercial scale are likely to rely heavily on the largest-capitalization, most-liquid stocks,” he said, using Apple as an example. “Having Apple in your ETF allows it to get really big [so] Apple is included today in ETFs emphasizing tech, growth, value, momentum, large-caps, high quality, low volatility, dividends and leverage.”
Nearly a year later, in another memo, Marks reiterated the point using Amazon. “Stocks like Amazon that are held in a large number of smart-beta funds of a variety of types are likely to appreciate relative to stocks that are held in none or just a few,” he remarked. “What all of this means is that for a stock to be added to index or smart-beta funds is an artificial form of increased popularity, and it’s relative popularity that determines the relative prices of stocks in the short run.”
Those dynamics are in part responsible for high concentration (figures below, from JPMorgan).
The implications for active management (any kind of active management) are bleak. Either you pile into the same names, only with leverage, or you underperform. It’s nearly impossible to beat an index that consistently returns 20% (or more) annually. Anyone with a few hundred dollars can track those indexes with virtually no error for just a few basis points.
In 2017, Wells Fargo described a “sellers’ strike” among clients amid an environment where passive investing was serving as “QE for US stocks”:
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).
If active managers 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 harder for any one active manager to go against the grain and sell. The result: Selling became anathema — almost a logical impossibility.
Where do we stand on all of this at the end of a year which saw the S&P 500 notch the second-most closing highs ever, driven by gains in just a handful of mega-cap stocks?
Well, as JPMorgan wrote this week, “market cap concentration has created a very challenging backdrop for active managers.” In fact, just 40% of Large-Cap funds outperformed this year (figure below).
That’s actually an improvement from 2020, when 70% of Large-Cap funds missed.
In the same note, JPMorgan’s equity strategy team wrote that “flows into Passive and ESG reinforced the concentrated leadership.” Ultimately, the environment “has made passive investing more difficult to beat yet again,” they added.
The trend is as unmistakable as it is inexorable (figure below).
In 2021, Passive took in some $600 billion versus around $90 billion of outflows from Active, JPMorgan went on to observe.
One common rejoinder is that this can’t go on forever and that the longer it does go on, it’s counterintuitively good for active management. As Marks put it in 2017,
Remember, the wisdom of passive investing stems from the belief that the efforts of active investors cause assets to be fairly priced — that’s why there are no bargains to find. But what happens when the majority of equity investment comes to be managed passively? Then prices will be freer to diverge from ‘fair,’ and bargains (and over-pricings) should become more commonplace. This won’t assure success for active managers, but certainly it will satisfy a necessary condition for their efforts to be effective.
Fast forward nearly a half-decade and active management is still struggling. Passive continues to grab market share, concentration (as measured by the weight of the largest 10 stocks in the S&P) is the highest in 50 years and blindly following a benchmark at virtually no cost continues to pay handsome dividends, figuratively and literally.
These dynamics do create myriad potential near-term opportunities, some of which JPMorgan identified this week. But from an existential perspective, the notion that, as Marks put it almost five years ago, “this seeming perpetual motion machine is unlikely to work forever,” looks tenuous.
Nothing lasts forever, but even if, to paraphrase Harley Bassman’s assessment of MMT, something isn’t viable over the long-term, it scarcely matters if one’s personal horizon doesn’t overlap its eventual denouement.