Second Quarter 2017
Three trends seem to be capturing the attention of the market in the past quarter: equity index investing, low volatility, and monetary policy normalization. Equity indices are widely viewed by many to be the only acceptable way for the retail community to invest in equities currently. The reasoning is sound. Most active managers underperform the index, making index investing, generally through ETFs, even more attractive. In addition to lower fees, index ETFs are more tax efficient than mutual funds. Most active managers in the long only community hug the benchmark, as significantly underperforming their benchmarks usually means losing their jobs, while outperforming provides little upside. Hence, we’ve seen a huge outflow of assets from active managers to index funds. According to the Financial Times, since January 2000, approximately $1.5 trillion in assets have left active US managers and moved to passive strategies. That means about 50% of long only equity investments in the US are controlled by, well, the people who make the index.
Bernstein Analyst Inigo Fraser Jenkins likened this to Marxism, saying “In a Marxist society at least someone is doing the planning of capital allocation, but in a predominantly passive market the capital allocation process is done by a marginal participant.” When someone moves from active to passive, they force the price of all the stocks that are in the index up, to the detriment of carefully selected securities of their former asset managers. This is all fine and dandy as long as the flow continues one way (a trend now 17 years in length). If I buy SPY now and fire my Fidelity manager, I will be pushing my basket of securities up, and active portfolio baskets of securities down. This cycle is repeated every time someone else does the same. The problem occurs when people begin to sell these passive products. As baby boomers enter the later years of retirement, they will become net sellers of equities. The huge savings of sovereign governments in Asia and the Middle East may need to be spent either defending pegged currencies or paying for the benefits of their populations. While new savers will emerge to buy, it would be imprudent to think these flows will happen in a coordinated fashion. Likely, an event will occur, like a toppled regime in the Middle East, a financial crisis in China, or a North Korea shelling of Seoul, which could cause the stock of wealth held in index products to flow out rapidly. In this sort of situation, owning the same stocks as everyone else in the world is a major risk to the careful protection of capital.
Intricately linked with the rapid rise of index investing, in our view, is the recent decline in volatility of US equities. First, the move to passive investing means most money moving into the market is not stock picking. It is just buying a basket of securities in equal proportion to their weighting in the index. Also, passive investors don’t choose energy over technology, they just buy the sectors based on their weights in the index. This would seem to create lower volatility in the market as there isn’t as much shifting of money around between individual stocks. As most indices are market cap weighted, any new money flowing into the market buys the most highly valued companies. Then, quant funds, who often try to capture momentum, buy those same highly valued companies, because they typically buy what is going up and short what is going down (another self-perpetuating positive feedback loop). The lack of economic surprises this year has also dampened volatility. Generally, the world economy is witnessing decreasing unemployment, modest growth, little geopolitical unrest (outside of Washington and North Korea anyway), all in a low rate environment. So, it’s not surprising that volatility appears low. No economic surprises equal little fear.
Why is this important? I think one area to monitor closely is the amount of leveraged money in risk parity funds. These funds use the measures of volatility in bonds and equities to leverage themselves in those markets. So, if S&P volatility is low, risk parity funds can buy more equities, and if bond volatility is low, they can buy more bonds. When both are low, they can increase their leverage without risking a major blowup in performance (at least statistically). But what if that changes? According to the CFA Institute, $400 billion in assets are currently allocated to risk parity strategies. The largest of these managers are Bridgewater and AQR. With equities richly valued, bond yields low, and a whole lot of assets leveraged 3-4x betting that the situation will remain that way, I think you create a recipe for disaster. The common wisdom is that bonds tend to do well when equities do poorly. In other words, their correlation to one another is typically negative. But what if this correlation flipped? An unwinding of the Federal Reserve’s balance sheet, the European Central Bank’s balance sheet, and the Bank of Japan’s balance sheet could create such a correlation flip. We know the Fed is preparing to carry out an unwind. Likely it will be cautious in doing so, but we don’t know how the market will absorb this supply. It could do so with the 10 Year yield at today’s 2.5% or at much higher yields. Either way, increased volatility from either bonds or equities could trigger a negative feedback loop where risk parity funds are forced to sell both bonds and equities at the same time.