Back in April, we showed that according to a Goldman Sachs report, the current run of chronic active manager underperformance began shortly after the launch of QE in 2009.
As discussed earlier today by Matt King in his report on "one-way" markets resulting from QE and ETFs, this period has been marked by "stubbornly low volatility and dispersion", something Goldman first observed four months ago:
Which brings us to what we concluded back in April in "Dear Hedge Funds: This Is Who Is Responsible For Your Deplorable Returns", namely that:
... while hedge funds, especially established ones with significant AUM, find the current status quo relatively comfortable - after all they get to clip their management fees year after year (forget the "performance" upside), extrapolating current trends in central-bank dominated markets would eventually lead to "active" extinction, and the complete domination of ETF-based and other low-cost passive strategies. Furthermore, taken to its thought experiment extreme, a situation in which there is only passive management would guarantee that the next market crash would be truly unprecedented with few hedge funds there to hunt for bargains.
More apropos, we also said that "ironically, the only event that can break this sequence of events would be a market crash, one which finally ends the current pernicious equilibrium and resets the capital markets. For that to happen however, both the Yellen and now Trump put would have to be eliminated. And that, as the past 8 years have shown, is easier said than done. For the sake of hedge funds and their dwindling assets under management, however, they better fund a way and soon."
Fast forward to today when we are delighted to remark that one of the best strategists on Wall Street has come out with exactly the same conclusion. As reported earlier, late on Friday Citi's always insightful strategist, Matt King discussed the phenomenon of "one way markets", and why between QE and ETFs, increasingly illiquid markets are not only herding asset managers into precarious positions, but "one-way markets which trend for extended periods very little volatility, but are then vulnerable to abrupt turnarounds."
This, as King then said, "leads us then to a final pair of paradoxes", paradoxes which those who read our April article, already knows. To wit:
The more the markets rally, the more money is crowded into ETFs and other passive index strategies, the more dispersion and volatility are suppressed, the harder it is for active managers to outperform and the greater is the tail risk – even as most asset classes do very well, asset managers get bigger, central banks think they are doing a good job and the world appears to be a safe place.
But groupthink and herding are in themselves dangerous. Stability breeds instability, as Minsky’s financial instability hypothesis famously put it. The harder central banks push, and the more markets rally, the greater the risk of an abrupt correction. The paradox for central banks is that achieving long-lasting stability may require a little bit more instability, a little bit more volatility, in the short run. A tantrum now might well restore balance to markets and help avert a full-blown crisis later.
The paradox for active investors is that such a tantrum or correction will almost certainly be associated with outflows from both ETFs and mutual funds. And yet it is precisely such an environment which active managers need in order to be able to outperform and stop forfeiting money to ETFs. The prolonged bull market which made them so big is also contributing to their undoing; in order to survive, they should be praying for a bear market.
Since King's conclusion is identical to ours, we can't disagree, although we will add one thing: with every passing month, the probability of a "controlled" tantrum becomes lower and lower, until it vanishes completely. That means that any attempted "controlled" crash - as King suggests - to unlock further upside may no longer be possible in a world in which even a 1% drop in the S&P results in a 50% or higher surge in the VIX as volatility sellers are margined out. Which in turn means that the Fed may have just one option left: push the market as high as it will go, and pray that not only a crash/bear market does not happen, but that by the time it arrives, the resulting depression will be someone else's problem.
In this regard, Yellen, who in just a few months will be replaced by Gary Cohn, is in luck.