Frank Thoughts: The Unwinding
Dave Canal
January 14, 2019

The recent pullback in the stock market has caused much angst in the media.  The strength of the economy is questioned daily.  It’s reminiscent of the investment chatter after the October “crash” of 1987.   The “coming recession” that never happened.   In my opinion, both periods were impacted more by the structure of the market rather than the economy.   In 1987 it was the buildup, and subsequent unwinding, of portfolio insurance.   In 2018 it’s been the buildup of passive investing and the start of its unwinding.  Both were intended to reduce risk.   Neither did.

Passive investing started in 1975 with John Vogel’s Vanguard index fund.   Eighteen years later, ETFs were launched by State Street Global Investors.   Both are capitalization weighted.  If – for example – Apple was 5% of the S&P 500, it would be weighted as such in an index or ETF fund.  This worked well in a bull market … until it reached a critical mass.   Then it became a self-fulfilling feedback loop.  No active manager is going to take a client and dramatically overweight certain positions in a portfolio.  He has a fiduciary position to “first do no harm.” He knows overweighting will dramatically increase the client’s risk when the inevitable downside period occurs as is now happening.  

However, investors became discouraged with the underweighting of active managers in the bull market and placed money in passive index and ETF investments.   They thus create a feedback loop of increasing dissatisfaction that continually repeats itself … until the market goes down.  When that happens, the overweighting becomes a miserable experience.    The FAANG stocks Facebook, Apple, Amazon, Netflix and Google are down as a group 30% this past year.  The result:  these five stocks are now having a disproportionate impact on the S&P 500 much as they did in the upswing.   More importantly, the positive feedback loop for passive investments changed to a negative one. 

 A feedback loop is best described as a circularity of action.  It exists between two parts - in this case passive vs. active - when each affects the other. The first part is the phenomenal growth of passive investments starting in 2010.  In that time frame ETFs grew, not counting index funds, from one trillion to four trillion in 2017.  At the same time, high-frequency trading became half of all stock trading and in the process obfuscated price discovery.  When combined with passive investing - also blind to price discovery - active managers underperformed their S&P 500 benchmark.  Thus money would leave active managers and flow into passive setting up a negative feedback loop for active.

For the past 10 years, correlation has been extraordinary.   HFT is now 50% of exchange volume.   Passive by itself is another 30-40%.   Now that the former positive loop for passive investing has turned negative, it will give rise to the ascendency of active managers.   After 50 years in the investment business, one thing I can say with certainty is that when something becomes the “accepted wisdom “… it is over.   It’s reminiscent of a similar experience in the 1960s.  Then one decision stocks were known as the “Nifty 50.” It was passive investing with 50 instead of 500.  The bear market of 1973-74 brought their unwinding much as the current market structure is doing now.

-Francis Patrick Boland

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