Passive investing has been on the rise since the inception of this extended bull market. According to Bank of America, inflows to passive funds were more than $1.5 trillion during 2009-2016 while outflows from active equity funds amounted to $340 billion during the same period. Deutsche Bank predicts that half of all the assets will be managed passively by 2021. Vanguard’s passive index funds now own around 5% of 490 S&P 500 companies, which is up from 115 at the start of the bull market. Business Insider notes that the market for ETFs registered a $876 billion increase in a single year.
The increase in use of passive strategies is understandable given lower costs and spectacular performance. See the infographic below:
The chart above shows the comparison between the S&P 500 index and active fund investing. It can be seen that active funds failed to outperform the S&P 500 index in a bull market while beating the index in a bear market. In short, the reason for the rise in passive investing during the last decade is the low-cost performance enabled by the bull market.
The point is that passive investing is being fed by a herd mentality. As passive managers post stellar performance, more funds move into passive, fueling the stock market further. It is a vicious cycle of a kind that fuels bubbles.
Why is passive investing a bad strategy now if the market is going up amid herd mentality?
Well, firstly, the bull market was being assisted by liquidity in the form of unconventional monetary policy during the last decade, which is about to disappear gradually. Secondly, the new Fed chair is set on increasing the short-term interest rate while there are no signs of improvement in inflation.
Now, this is going to happen. Higher short-term interest rates will tempt institutional investors to move funds into less risky assets. Decreasing balance sheet assets of the Fed will also put a constraint on the liquidity of financial institutions; institutions will re-balance their portfolios toward fixed-income securities. As a result, passive equity strategies will perform poorly, and funds will start to shift away from passive investing due to the same herd mentality that fueled passive investing in the first place.
We are not arguing against the benefits of passive investing in a bull market, which are hard to beat. However, the same can’t be said for passive investing in a market that is expected to move in an opposite direction due to monetary tightening.
The Fed’s hawkish stance has finally started to pressurize the stock market
The balance sheet of the Federal Reserve has already started to shrink and the federal funds rate is on the rise. See the charts below:
You have probably spotted what’s interesting, but we will rehash anyway. As securities began to decline and the short-term interest rate started to rise, the S&P 500 has had a hard time registering growth. In fact, the index is down ~8% since touching a high of 2872 towards the end of January 2018. It’s not a coincidence that the decline in the stock market is coinciding with the increase in the federal funds rate and reduction in QE assets of the Fed. This is the primary reason, we think, that passive funds are going to underperform going forward.
The Indifference Argument
Some critics argue that QE did nothing to boost equity markets, and hence the reversal will also have no impact on the market as well. We addressed this question in detail here. A followup question from the skeptics is that the Fed already started unwinding its balance sheet last year but there was no impact on the equity market. Well, this question needs some answering here.
First, the impact of reduction in market liquidity is not immediate.
There’s a lag between the removal of liquidity from the system by the Federal Reserve and the corresponding effect on the stock market. The transmission of policy takes times. It’s as simple as that. Investors don’t rebalance their portfolio in real time in response to the Fed’s balance sheet reduction.
Second, the rate of decline in Federal Reserve's balance-sheet assets is minuscule as of now.
The initial cap on the dumping of the securities was just $6 billion, which is nothing in comparison to the $4 trillion on the Fed’s balance sheet. As the cap gradually increases, the impact on the stock market will become noticeable.
As the Fed removes liquidity from the market, institutions will have to withdraw from the equity market. From where will the financial institutions find the funds to keep buying the securities that the Fed is so keen on unloading now? Well, institutions will have to withdraw funds from the equity market. Interestingly, SA contributor The Heisenberg noted the following in one of his recent pieces.
Oh, and some of you apparently sold some stocks, because $25 billion was yanked out of equity funds this week.
Third, long-term interest rates should cross a threshold before investors can abandon equities in favor of fixed-income assets.
It doesn’t make much of a difference if the yield is 1.25% or 1.5%. However, the decision of allocation becomes an important one when fixed-income yields are, say, above 5%. There is no magic rule of thumb for the threshold. But once yields start to move closer to what the stock market can offer in terms of return, allocation decisions can begin to change in favor of fixed income securities. At a short-term policy rate around 1.5%, we are not there yet. But the balance sheet reduction of Fed will most certainly test the threshold as we move towards a high interest rate environment.
Moreover, supply of fixed income securities will keep bond prices checked.
A natural question is that if investors move towards fixed-income assets, wouldn’t yields come under pressure again? Well, to answer this, we should know why the Fed agreed to buy some of the fixed-income assets from big financial institutions like Fannie Mae and Freddie Mac. It was simply because of non-performance, or to be less blunt, high risk of default of those securities.
Now, when the Fed unloads those securities, there will be no demand for such securities, leading to a price collapse and high yields across fixed-income spectrum due to oversupply. The point is that allocation towards fixed-income assets is expected to increase in the institutional arena over the next couple of years. Consequently, equities will remain under pressure.
Increasing short-term interest rates and reduction in balance sheet assets of the Federal Reserve will move yields on fixed-income securities to a threshold where institutions will favor allocation to fixed-income assets. This is expected to put pressure on the equity market during the next year or so.
Moreover, as the stock market is dominated by passive investing strategies, poor returns from index investing going forward can allow the herd mentality to foster, further pressurizing the stock market. Therefore, in our opinion, low-cost index strategies will underperform during the next couple of years. Investors’ best bet in equities is to stick with value assets across sectors.
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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This publication is for informational purpose only and reflects the opinion of Focus Equity’s analysts. This opinion doesn’t constitute a professional investment advice. Our senior technology analyst, Soid Ahmad, compiled this research piece. Focus Equity is a team of analysts that strives to provide investment ideas to the U.S. equity investors.