There have been many words and frustrations published regarding the shift of investors from active to passive funds. To our knowledge, there have been none highlighting the shift in psychology that takes place when investors transition to becoming passive index investors. We examine evidence here that strongly point to a majority of investors in the market today being short-term and momentum-driven at the same time underlying stock liquidity is declining. This momentum shift has created a market of "haves" and "have nots." Given tax dynamics in 2019, we believe the next move in this momentum-fueled rally, as it most usually is, will be higher. Yet, as research on momentum crashes highlights, the correction could be quite painful for the majority of investors who are picking up pennies in front of the steamroller.
The stock picker is dead. Long live the stock picker.
As is no surprise to this audience, the fund management business has now become a majority passive industry. This year, passive investment funds overtook active to become more than half of equity investment funds in the United States. These funds lower costs by removing the selection mechanism for their investments and only seek to replicate an index. Importantly, they also take advantage of a tax loophole which eliminates taxes on underlying realized gains and losses throughout the holding period, further raising the bar for active managers to overcome to stay competitive.
As a result, your author personally believes that actively managed investment funds are in terminal decline. Not only do active funds routinely underperform the index as a whole, but they also carry tax inefficiencies, which are only worsening, and higher costs.
Research from JPMorgan suggests that while passive funds are half the industry, up to 90% of trades on exchanges today are performed by robots or passive fund rebalancing. That means the individual stock price discovery has become a largely insignificant factor for securities trading. To the novice investor, my mom in a recent discussion, "that sounds like the big short all over again."
Indeed. Other more intelligent investors than us have recently made several important conclusions about the rise of passive investing, namely that the underlying liquidity is vanishing for individual stocks, particularly relative to the amount of capital that is betting on them, as is the price discovery mechanism. The shrinking liquidity is coming at the same time index investing is increasing cross-security correlation and is lowering individual stock volatility. Increased cross-asset correlation is the result of investors becoming less focused on the underlying fundamental reality of each specific asset. It's "all up" or "all down" regardless of the constituents' fundamental performance, or increasingly, a market of haves and have nots.
The lower liquidity in individual securities extends to the Treasury bond market, where Dodd-Frank financial regulations have eliminated the ability of broker dealers to carry inventory on their books. This is perhaps the most worrying part of the liquidity evaporation, as a very large buy order for Treasuries in a short time-frame can generate a collapse in reference bond yields, sparking its own self-fulfilling stock panic.
Cross-asset correlation is also coinciding with lower underlying volatility. The lower volatility, as pointed out by Mike Green from Thiel Macro, in a terrific Hidden Forces podcast, is encouraging investors to use greater leverage in trying to boost returns. In a quest for boosting yield in a world of low yields, investors are writing more insurance. Following in the intelligent footsteps of AIG prior to 2008, more investors are now writing market-linked insurance contracts, which replicates the market returns without needing to lock up the capital required to invest in the market. Lower volatility and increased leverage have been fueling the stock market higher, while individual investors continue to withdraw capital from the market and earnings are growing at a very lackluster pace relative to the index growth. In short, the market is detaching from fundamentals, as all momentum movements have done in the past.
As Green points out, the beginning of the passive index fund was conceived with the efficient market hypothesis as the cornerstone theory anchoring the soundness of the investment. This assumes that markets perfectly reflect all information in asset prices, which implies that very few, if any, can out-predict the market or out-perform the market.
"It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so." - Mark Twain
It's amazing to us that despite much evidence to the contrary, the efficient market hypothesis continues to form the bedrock upon which most investing and investment theory is built.
On an underlying and individual security view, we have seen a consistent pattern of the market incorrectly pricing information that is given to it. Furthermore, the assumption that all information is known and priced into a stock runs contrary to our experience gleaning insights from competitors, suppliers, or customers of companies to derive highly useful information and a differentiated point of view, far different to what the market and consensus believes at times. Yet even without this work, we find consistent patterns of the market under-reacting or over-reacting to new information. While much of this news and drama is just noise, much of it carries information that can help the fundamental investor better price an asset.
Over the past couple of decades, a new class of economists and investors has put forward hypotheses and theories that more closely study the role psychology plays in affecting investment results. They all point to a market which consistently leads investors to making biased and flawed decisions.
While behavioral investors like Michael Mauboussin have given free tools to the investor to help make sense of this noise, most still ignore the behavioral aspects of investing, which for public market investors, we think are the primary drivers of investment returns in the short-term. Michael has led behavioral investigations into investor expectations and his work has greatly helped us to better stay ahead of others' buy or sell decisions, to the extent they are predictable.
But much of those behavioral-based expectations are only concerned with human actors attempting to discover the fair price of an underlying stock. That behavior is perhaps now only covering 10% of the daily trading activity. Increasingly the counter-party is a momentum-driven price-agnostic buyer. Since we live in a highly stochastic world, we cannot predict when, but we do believe this price-agnostic buyer will eventually turn into a price-agnostic seller.
The stock market, with its volatility, overreactions, and drama which is sensationalized by financial media, consistently triggers System 1 thinking. System 1 is the animalistic part of our brains, it carries our survival instinct and is quite important to the normal functioning of a human, particularly in the wild. It got humans from 400,000 BC to 4,000 BC. It takes what it can for itself. The amygdala is the fastest-thinking and loudest part of our minds.
Yet, in a knowledge-based economy, and frankly, since the beginning of organized civilization, System 2 is the value creator. System 2 is the thoughtful, deliberate and rational mind. It is the part of our brains that realizes sharing and collaboration are key to value creation beyond what we can do on an individual level.
Nobel laureate Daniel Kahneman, whose work has sought to understand psychological biases that lead to poor judgment, is quite pessimistic on the ability of humans to improve upon their human biases triggered by System 1. There are certain illusions which, even after knowing the illusion is just a visual trick, still cause the viewer to see the original image with the bias firmly intact. Even after knowing the horizontal lines in the Müller-Lyer illusion are the same length, we can't help but look at the original image and perceive a slight difference.
Exhibit 1: Müller-Lyer Illusion
As he published in the Harvard Business Review, in an article entitled "Noise: How to Overcome the High, Hidden Cost of Inconsistent Decision Making," Kahneman's solution to his pessimistic view on humans overcoming biases has been to advise them to rely more on algorithms. Processes and systems can help reduce the amount of noise infiltrating the actor's conscience. The theory is that if one filters out the noise from the signal before it gets to the receiver, then that individual can improve his judgment. We are eager to read Kahneman's upcoming book on noise.
The investors who have relied on target-date funds have freed themselves from acting frequently, as they rely on automatic rebalancing. This algorithm has actually reduced investors' tracking error to the underlying performance of the fund. The returns themselves have been less impressive than recent equity index returns, but investors are less susceptible to momentum and herd-like behavior in these funds. In the most recent annual study of realized performance relative to the underlying performance, Morningstar observed that investors on a rolling 10-year basis have actually outperformed the underlying performance of their target-date funds. This is a rare case of the algorithm helping remove greed and fear from the equation, and investors behaving from System 2 rather than System 1. The same cannot be said of investors in funds with more volatility.
Green touched on this exact hack when discussing the role of passive funds to the individual investor. "The underlying uncertainty about the validity of the advice that you receive encourages people to default to the machines." Unfortunately, while investors in target-date funds are perhaps defaulting to the machines, we actually believe most investors shifting to passive strategies are still trying to time the market. But those investors are increasingly loaded into index funds rather than actively managed funds, as evidence suggests.
Decades of research by Morningstar have consistently confirmed that investors are pro-momentum when it comes to their investments in funds. The experience of the global financial crisis confirmed that investors trailed the underlying performance of their funds by a considerable spread of 2.0% per year for the decade ended in 2010. Fund flows confirmed substantial equity fund withdrawals in 2009 and 2010, just as investors were ill-advised to do so.
According to recent Morningstar "Mind the Gap" reports, the performance gap, while still considerable, has narrowed to 0.56% for equity fund investors on a rolling 10-year basis. We have two observations from this narrowing gap. First, clearly a lack of volatility in the markets has whip-sawed investors less. According to Morningstar analysts, volatility correlates positively with investor redemptions and subscriptions, so the lack of volatility has perhaps led to less subscription and redemption activity. A second observation is that this fairly substantial narrowing of the gap has most likely meant that the more reactive investors, with higher turnover, have now shifted their holdings to ETFs and passive funds.
Exhibit 2: Volatility and investor Realized Returns from Mutual Funds - 2009-2018
A worrying 2018 ETF Investor Study from Schwab confirmed that of the investors interested in and investing in ETFs, 83% of investors somewhat agreed or strongly agreed with the statement "ETFs provide me with flexibility needed to react to short-term market swings." Furthermore, 60% of investors admitted to buying and selling ETFs more frequently during periods of volatility.
That should initially cause us to cheer, as volatility brings more opportunities to the entrepreneurial investor. Yet, unfortunately looking at these statistics and overlaying them with Investor fund flows, investors have shown a strong tendency to flow into funds nearer to market peaks only to substantially withdraw their funds when the markets are at their backs. They are pro-cyclical, not counter-cyclical.
Exhibit 3: EPFR Fund Flows Around the Global Financial Crisis
Part of the recent rotation from equities into bonds over the past two decades can be blamed by an aging western world population. As investors age, they allocate a heavier portion of their portfolios over to bonds, as they can tolerate less volatility and need to prioritize income. That low yield environment has created a worldwide desperation for yield. Insurance products with implicit leverage are experiencing a torrid bull market, with less understanding by this investor base of what they're actually exposed to.
There's a reason why the Morningstar "Mind the Gap" surveys almost never publish positive performance gaps between actual fund performance and realized performance for equity funds. They invest closer to the top and redeem closer to the bottom. Target date funds, which are mostly in 401(k) accounts, and are very rarely touched, are the rare exception.
Since 2007, when passive funds were only around 20% of assets under management, the redemptions of investors from active funds into passive funds has contributed to a positive performance gap for investors invested in passive funds. According to Morningstar's 2017 "Mind the Gap" report, US equity fund investors experienced a 0.91% annual performance deficit to the actively managed funds' underlying performance. This flipped to a positive 0.55% performance gap for investors in passively-managed equity funds. Fund flows, according to EPFR, have tended to strongly correlate to market performance, with investors blaming the fund manager for the short-term underperformance. These flows have shifted to passive funds at the exact moment when adding to a "pullback" in the market made the most sense.
Exhibit 4: Fund Flows Shift from Active to Passive ($T)
Some have taken this to mean that investors are better-behaved in passive funds, but given the last decade has seen an unprecedented build-up in passive investments, with low underlying index volatility, we cannot be sure of this until the next major correction in the market. In fact, there is reason to believe that many of the investors who are most likely to "time the market" have already shifted over to ETFs given the intra-day liquidity that many prioritize.
Behavioral studies of investors regarding individual stocks have consistently confirmed that investors are actually contrarian when it comes to individual stock-picking. Behavioral economists refer to this behavior as the "Disposition Effect," which describes the tendency for investors to sell winning stocks and hold onto underperforming stocks.
Exhibit 5: Summary of Academic Research on the Disposition Effect
Our firm has been fortunate enough to have sophisticated investors who have added to their subscriptions during periods of under-performance. While we have yet to conduct an internal review of realized performance to underlying performance, our consistent retention rates of over 100% a year, plus the counter-cyclicality of the flows, suggest our investors are actually outperforming the underlying performance of the portfolio. We believe this is only possible because we publish highly detailed research for our investors, and the causal link between an underperforming price and a buying opportunity has been restored.
In funds where investor education is not prioritized, the under-performance of a fund is blamed on the manager and is rarely seen as a buying opportunity. EPFR fund flows consistently report major fund redemptions from equity funds in periods of a market correction, the exact wrong time to be redeeming on a fund.
Examining the evidence, we believe the contrarian attitude investors take towards individual stocks flips into a momentum attitude when investing in a fund. Good decisions are more easily made on specific cases. It's far easier to determine whether or not a specific house or a specific stock is a great buy at 20%-off than it is to understand whether or not the entire real estate or stock market is the same great buy after a 20% correction.
As many investors have pointed out in recent months, index investment strategies detach investor behavior from the fundamentals of the underlying constituents. All constituents are treated equally despite the very different fundamental operating differences between the constituents. This is perhaps most dramatized by a stock we are short, Boeing (BA), which is only months away from facing a very precarious balance sheet and liquidity problem given the continued grounding of the 737 Max. Boeing is still 9% of every Dow Jones passive index fund. The investors in these passive strategies are most likely completely unaware that so much of their capital is tied up in the very plane they are reticent to fly on. As my mom said, "this is the big short all over again."
It's a repeat scenario of investors that have a limited understanding of what they own. Except this time, they have liquidity on any given trading day. And those trading days are now much more driven by passive flows than ever before. In trying to execute an order for Boeing in the last hour of trading on a Friday in September, a very insignificantly-sized order we had, moved Boeing's stock by over 10 bps while we were trying to get the sale completed. In a future post, we'd like to explore underlying stock liquidity, which anecdotally has been contracting for most equities, and the mismatch it has to the trading volumes of the passive funds that own these constituents. We are finding increasing areas where highly liquid ETFs own deeply illiquid underlying assets.
A worrying 83% of ETF investors emphasize the ability to time the market with short-term moves as the reason why they prefer to hold passive investments. That means when the stock market stops its meteoric rise higher, as much as 40% of investors could rush for the exit at the same time. This is not only the "big short" all over again, but it includes the same drivers as the 2010 flash crash, when companies like Procter & Gamble (PG) and Accenture (ACN) were traded at pennies by the machines that had a mandate to sell. Robots have still not learned common sense.
Given the conservative positioning of most investors today, with cash being the most preferred asset and money market funds receiving the highest fund flows over the past year, we wouldn't be surprised if the momentum of the market continued at its torrid pace. In fact, over 2019, as equity markets posted their best performance in a decade, actively-managed funds continued to receive unabated redemptions. That means investors in actively-managed funds this year will receive a tax bill, perhaps accelerating the shift away from active to passive. That would be fitting for a momentum trend in the final stages of the bull market.
As professors Kent Daniel and Tobias Moskowitz wrote in a paper entitled "Momentum Crashes", "momentum strategies have historically generated high Sharpe ratios and strong positive alphas relative to standard asset pricing models. However, the returns to momentum strategies are negatively skewed: they experience infrequent but strong and persistent strings of negative returns." Unfortunately their research found that when momentum draws down, it's not a simple 10-20% correction. It's a 50-90% drawdown.
Exhibit 6: Worst Historical Months for Momentum Stocks
To us, at this stage of the cycle, it no longer makes sense to be in the momentum trade. The modern passive investor is saving basis points by switching to passive strategies, only to potentially get crushed when over 80% of their fellow investors become price-agnostic sellers. It's the definition of picking up pennies in front of the steam roller. We want no part of this game and have been actively working to eliminate all exposure in our portfolio to co-ownership with momentum-driven passive investors. Given 69% of our gross portfolio (83% net) is being managed by insiders with significant ownership stakes, our long positions are systematically under-indexed to passive funds. Less than 10% of our portfolio companies are co-owned by passive investors, and founders or managers outnumber the passive funds' ownership by 3x. Yet we're still looking to bring the net co-ownership of the portfolio to at least zero, and potentially net short over the coming year.
As a society, we have never seen a stock market correction take place when as many as half of investors have been promised they can exit within minutes of making the decision. We are not optimistic about the outcome of this very large and reckless psychology study taking place.
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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