Hedge Fund CIO: "Expect Enormous Losses In The Next Correction As There Is No Price Discovery In Index Investing"

In today's excerpt from Eric Peters Weekend Note to clients, the CIO of One River Asset Management focuses on the one topic that is first and foremost on the minds of the active investing community: the unprecedented shift from active to passive management, and what it means for not only the industry, but for markets during the next "normal correction."

“Each day since the election $1bln has moved from active to passive management,” said VICE, standing in the shadow of America’s mountain of private wealth assets. When you buy the S&P 500, you pay the prevailing price for every one of those stocks.

 

 

“There is no such thing as price discovery in index investing.” And there will be no price discovery on the downside either. The stocks that have been blindly bought on the way up will be blindly sold.

 

“When these markets do finally have a correction there will be no bid for many of these stocks.” 

 

“The people who are indexing now are the same ones who were selling in 2009,” continued VICE, agitated. “I just spoke at a conference filled for wealth advisors from all the major players. They say the same thing - today’s buyers are not long-term investors.” They’re guys who put $1mm into index ETFs.

 

“When they lose 6%-7% and decide to sell, who will be on the other side of those trades?” And the stocks that will be savaged worst will be the ones that lagged the indexes on the way up. “It reminds me of 2000, when people piled into the QQQs.” 

 

“I don’t know when the next major crisis will hit, no one does,” admitted VICE. “But I do know that even in the next normal correction, the market’s losses will be amplified enormously by this move away from active management.”

 

$500bln has shifted to index investments, distorting the way equities are valued and the historical relationship between short sellers and buyers. This flow creates artificial demand for poor-quality securities that have few natural buyers. “And now even Warren Buffett is telling investors to shift to passive.”

And a bonus: the world as seen through the eyes of active managers.

 “Long-only investors have the longest memories,” he said, just back from a grueling march through countless offices. “They don’t believe bond yields will ever rise.” Secular stagnation has cast a long shadow. “The age of disruption has shifted their psyche too.”

 

Every day their assets decline, fees too. Their job future is more uncertain today than in 2008. So much for the return of animal spirits, the running of the bulls. “And these guys are not alone. For all the talk of bullishness, it’s hard for anyone to be euphoric when our industry is in such decline.”

We doubt, however, that as the active managed industry slides into the sunset that the rest of the world will shed too many tears.