Wednesday, April 21, 2021

A theory of (almost) everything for financial markets

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Two young fish are swimming in the ocean, passing by an older fish, which says, “Hey boys, how’s the water?” The two youngest fish continue to swim, until one turns to the other and asks, “What is water?”

The late writer David Foster Wallace used this parable to illustrate how “the most obvious, pervasive and important realities are often those which are most difficult to see and speak”. For some analysts, this is also the perfect way to describe the pervasive and underestimated effect. passive investment a in the markets.

Quantitative oriented investors see their the models sparkle? Stock valuation at illogical highs? Driving stockpickers reduced to helpless dunces? Strange movements in the bowels of the markets? Supposedly idiosyncratic titles moving together as if they were doing a tango? The strange phenomenon of most stock market gains happen overnight rather than during the trading day?

All of this and more can be put at the feet of the rising tide of passive investing, according to a group of skeptics led informally by Michael Green, chief strategist at Logica Capital Advisers. In some ways, what he argues amounts to something akin to a “theory of (almost) everythingFor the financial markets and Mr. Green has made it a personal crusade this year. The arguments are convincing enough to warrant consideration.

It is true that the indices tracked by passive funds have over time transformed supposedly neutral snapshots of markets into something that actually wields power over them, thanks to the growth in passive investment.

Mr. Green argues that this explains why active managers see their performance deteriorate as passive investing grows. The more money index funds earn, the better match their holdings to their weighting, and the harder it is for traditional discretionary investors to keep pace.

The broader growth trend also partly underpins the rise in valuations. The average fund manager typically holds around 4 to 5 percent of assets in cash, as protection against investor capital outflows or to take advantage of opportunities that may arise. But index funds are fully invested.

In other words, three decades ago, every dollar invested in equity funds meant that 95 cents would actually go to stocks. Today it is closer to full responsibility. Considering the trillions of dollars that have gushed into low-cash-consuming index funds, this is leading to a secular rise in valuations, Mr. Green valorize.

In addition, since indices are size weighted, the rise in passive investing mainly benefits already rising stocks. This makes the increasingly heavy stock market as the big gets bigger. This bypasses the popular strategies of many quantitative hedge funds to seek to exploit “factorsLike the historical tendency for cheap or smaller stocks to outperform over the long term.

It also increases correlations, with members of the S&P 500 walking or falling more in unison than in the past. And that might help explain why so much of the stock market’s gains occur outside of the normal trading day. Many index funds buy in the closing auction.

Nevertheless, the argument that passive investing has become a nefarious force that disrupts the natural order of markets is still far-fetched. It is presumably a factor in many phenomena, but it is impossible to disentangle it from the multitude of much larger forces at work.

Line graph of cumulative net inflows over the past decade, bonds and stocks (in billions of dollars) showing Aggressive Liabilities

Yes, stock market leadership is more limited than in the past. But it’s not as if today’s giants are mirages conjured up by index funds. They are often extremely profitable semi-oligopolistic companies that grow at a breakneck pace and operate globally in a world of zero interest rates. In such an environment, it is natural for the markets to become more concentrated.

Passive investment probably helped the hot stocks with the momentum behind them. But the ever-changing market ecosystem has always led to certain segments of the stock market outperforming or underperforming.

Above all, the theory that passive investing would inevitably explode and drive a hole in financial markets when the tide receded seems a bit ludicrous today.

Over the past twelve years, passive investing has gone through two big stress tests – the financial crisis of 2008 and the pandemic of 2020 – and came out of it greatly reinforced. Even some skeptics now quietly admit that the structure may be stronger than they previously thought.

Finance tends to go too far in all trends and passive investing is undoubtedly no different. But we’re not quite there yet, and it’s unlikely we will be for years to come.

robin.wigglesworth@ft.com

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