"By denying scientific principles, one may maintain any paradox." - Galileo Galilei
In markets, the pendulum swings from one extreme to the other. And that pendulum has swung so far towards passive indexing that there is likely a bubble in it.
Consider a few facts here. The clearest beneficiary of the move towards passive investing through indexed strategies is Vanguard. According to Ceruilli Associates, through the end of November last year, Vanguard got more net inflows in their funds than the next nine fund companies combined. In 2015, Vanguard set a record on an annual basis for fund flows. Active ETFs? Please - they rarely get anywhere near the same kind of assets as passive ones like the S&P 500 ETF (NYSEARCA:SPY). The world became a believer in passive vehicles in a hurry.
This is a bubble, and one few seem to be realizing or appreciating is happening in their own portfolios. By definition, if everyone is moving towards passive investment strategies, more active anomalies must be popping up because there are fewer people looking for them. There are fewer players attempting to arbitrage those anomalies away.
The reason passive investing works is because active investors are forcing that "market efficiency," a key idea which relates to the Grossman-Stiglitz Paradox. Markets are efficient only when there are active anomalies which many attempt to arbitrage away, forcing markets to their true "informational" value. We are at a non-equilibrium point now such that so much money has rushed into passive strategies that they simply cannot be efficient because new anomalies are popping up which few are actually looking for.
Selfishly of course I want this to be true. Our investment strategies are the extreme of active tactical rotational management, focusing heavily on leading indicators of volatility to help answer the question of when to play offense, and when to play defense. Year to date, we've managed that quite well through either our Treasury or defensive sector rotations. I suspect the cycle for active strategies is on the cusp of a new multi-year cycle. But because flows act with a lag, this will only be realized long after the trend has already occurred.
As to current markets, defense remains warranted. This is an odd juncture in the sense that stocks have not fallen, yet there is an unusual amount of hedging and defensive posturing. A contrarian would argue this is bullish. However, it could very well be that this time, the active crowd which does hedge actually will be right. After all, it's a much smaller sample, and perhaps more elite group of active players than ever before.
This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.