I have been meaning to write this post for quite some time. As an ex-ETF trader, I have watched with bemusement as investors have both embraced and shuddered at the wide adoption of ETFs. But most pundits are missing the larger picture. ETFs are just a symptom of the bigger phenomenon. The true battle lies in the passive versus active debate.
Let me get this out of the way right off the bat. I have no dog in this hunt. I see both the benefits and the negatives to each side. Yet as a trader, I definitely have a view on which end of the boat is leaning lopsided right now.
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Lessons from triple witching
But first, let me tell you a story. I was lucky enough to have a ringside seat for the coming of age of equity index derivatives. Sure they existed before my time, but the true widespread global adoption occurred in the 1990’s. In Canada, when I first sat down on the institutional desk, clients had little interest in what the young kids with their fancy SUN workstations were doing. Yet as money flowed into the derivatives complex, what had first just been a strange little science experiment, suddenly started moving the underlying market. Our index arbitrage flows became significant, and regular plain vanilla clients began took notice.
Along with the increased index arbitrage flows came this bizarre triple witching expiry. When open interest was small, these expiries were minor. But as the usage of derivatives expanded, one morning we experienced an imbalance that was uncomfortably large. Being index traders, we instantly understood what had happened. Someone was letting a whole bunch of exposure expire into the open, and therefore there was a very large, and very real, index sell basket to execute at the open.
Many institutional clients were not used to trading on the open. Most often, they let retail orders and market makers set the price, and then after it settled down, they would give us their orders.
Given that institutional clients were not interested in trading at the open, there was little liquidity for the large expiring sell basket. Sensing an opportunity, we bid spec for a decent portion of the sell imbalance, hoping to get a good fill which we could then offset in the futures market. The trouble was, not nearly enough market participants joined us, and the market gapped down huge. It was a terrific trade as the opening settlement was many hundreds of basis points below the previous close.
There was no fundamental reason for the market dislocation. It was simply a matter that not enough participants understood what was happening.
Rest assured, immediately after the violent open, our phones were ringing off the hook with clients wanting to understand what the hell happened.
With some education, active managers learned how they could take advantage of this liquidity demand at expiry, and from then on, these fundamentals clients lined up to offset the morning imbalances.
And that’s how markets work. Opportunities are arbitraged away by market participants attempting to take advantage of mis-pricings.
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End zone dances are a bad idea
When I see a passive manager making fun of a fundamental investor, I am perplexed. The passive manager’s very existence relies on fundamental investors keeping markets efficient. You can’t claim the market is too efficient to beat, therefore you shouldn’t try, and then laugh at everyone who does. The paradox is that your success as an indexer depends on everyone else continuing to try. The passive investor should be thanking the active guys, not mocking them.
Which brings me to a twitter exchange that I watched this weekend. I won’t name names because it isn’t important, but it was between two popular market pundits - an extremely well known money manager (and social media star), and the other, a semi-retired macro manager, revered within the hedge fund community. What struck me as odd was that the money manager, seemingly-out-of-the-blue, posted an article from last year where the macro manager had forecasted an increased chance of a recession in the coming year. The problem was that he had included a big LOL with the date on it to show how badly this macro guy had whiffed.
Now my immediate reaction was what a dick move. We all get it wrong sometimes. This macro manager is no perma-bear. He had a solid line of reasoning on why the economy might roll over. Shoving his nose in it like an ignorant dog owner might toilet train his puppy seemed mean spirited.
Now, both of these guys are way out of my league. I am pretty sure either could buy me over many, many multiple of times (at least I assume so given the out-of-reach-for-most-humans classic sports cars the regular money manager posts on his blog with little tidbits about which one he is buying.) And I am sure, the last thing the macro manager needs is me defending him. He runs with the big dogs and probably just had a good chuckle at the cheap shot slung from the social media star.
But I think their exchange represents the perfect analogy for what is happening in the market right now. It epitomizes the epic battle between passive and active, and clearly demonstrates which side is feeling smug and sure of themselves.
Climbing the ultimate wall of worry
The 2008 Great Financial Crisis scared a lot of people. I remember my old man telling me how his father’s generation was scarred by the Great Depression. They were constantly worried it would occur again, and to a large extent, they were always saving and preparing for its return. Well, our generation is not that different. In 2008, investors abandoned the stock market, and were extremely reluctant to return.
Have a look at this chart of the investment flows over the past decade:
Investors fled stocks faster than Lindsay Lohan leaving rehab, and rushed into bonds. This chart is a little bit dated, so it doesn’t show the recent surge into equities, but it gives a picture of the attitude that prevailed in the years following the Great Financial Crisis.
The important thing to realize is that most everyone was scared following the GFC. There were precious few equity bulls.
Armed with a stack of blue tickets, Central Banks were determined to not let the Great Depression repeat. So they bought, and they bought, and they bought. It started with the Fed. Then the Bank of Japan joined the party. The ECB tried to resist, but that just caused all the deflation to be exported to the EU, and eventually even the Germans acquiesced and allowed the ECB to expand their balance sheet. It has become an orgy of Central Bank buying. It’s so obscene I think even Caligula would blush.
I am not here to tell you how this will cause some end-of-the-world collapse. In fact, I think this will eventually cause a monster melt-up in all prices (including non-financial ones), as opposed to some deflationary crash. But what I would like to stress is that Central Banks have pushed financial asset prices higher. No doubt about it. Whether it was by the lowering of the risk free rate to mind boggling low levels (forcing investors out the risk curve), or by the actual purchase of risk assets (ala SNB and BoJ), financial assets have not been rising because of sound fundamentals, but instead because the economy has been so sluggish, causing even more Central Bank monetary stimulus.
Investors have been reluctant to embrace risk assets. They have reluctantly bought, not because they felt it was a compelling bargain, but because they had no choice. Faced with ever increasing life spans, combined with less and less government retirement plans, individuals realize they have not saved enough, and with the horrendous financial repression, they have no alternatives.
Markets always climb a wall of worry, but this was no wall. This was a mountain. And no regular mountain, but an Everest type imposing monolith.
The one type of manager who got it right
All of this uncertainty made passive-rule-based-long-term managers the stars of this cycle. Everyone else was reluctant to climb aboard the Central Bank fueled rally, but not this crew. Their rules forced them to be long, regardless of all the negativity surrounding markets. Managers that embraced this strategy are now geniuses and heroes melded into one.
These managers were unique in that they were a member of the elite few brave enough to be fully invested. Low bond yields didn’t scare them. Record equity valuations didn’t stopped their buying. They had a plan, and they stuck with it.
And hats off to them. Any level of cash or under-weighting of beta has been nothing but a drag on performance. Not only that, but since this group often advocates passive investing, they were concentrated in the highest market capitalization stocks. Which also happens to be the perfect vehicle for Central Bank risk asset buying.
Think back to the rally of the previous couple of years. Was anyone buying because stocks were outright cheap? Not a chance. Sure you could make the argument stocks were inexpensive when compared to the risk free rate, but for the past few years, buying stocks was somewhat a leap of faith.
I would argue the only group that fully caught this move were the disciples of “stocks/bonds in a diversified portfolio” for the long haul. Unless you were systematically executing a fully invested portfolio management strategy, this was an extremely difficult market to stay fully invested.
Nothing is new
Which brings me back to our money manager who is busy taking pot shots at macro managers who attempt to make fundamental calls about the economy’s prospects in the coming year. This money manager happened to have the perfect strategy for the past few years. Given his beliefs, I assume he was fully invested, concentrating on market capitalized stock index ETFs, with some low cost broad based bond ETFs for diversification. I don’t know this for sure, but given his comments, I would be surprised if this wasn’t his MO.
But the real dangerous part? Since this is the only strategy that seems to have worked over the past few years, investors are chasing this investing style with a zeal last seen in Phoenix real estate in 2006.
Active investing has become a punch line for a bad joke. Why bother picking stocks? Central Banks and the ETF buying public are just sending up the biggest ones as they make up the majority of the ETFs. And even when there is some “fundamental” analysis occurring, it mostly consists of some young data scientist putting the latest three years of data into a “factor” model and choosing more of the names that have been working for the previous three years.
Financial assets have been goosed higher through Central Bank balance sheet expansion, and at the very moment where fundamental analysis is most needed, investors have completely abandoned it. Active managers are being fired left and right. They are being replaced with passive ETF strategies. Hedge funds of all stripes are being stripped of assets, and in their place, more beta fueled indexing.
This story is as old as time. As much as everyone thinks they don’t chase the hot investing fad, the crowd always piles in at the end.
We have seen this play out each and every market cycle. Don’t forget that in 1999 Warren Buffett was some old codger who needed to be put out to pasture because he didn’t understand the new economy. Or how about GMO having a majority of their assets flow out the door in 2006 because they weren’t participating in the frothy market, only to see their performance crush most of their competitors in the next couple of years.
The fact that fully invested passive managers are doing over-the-top-victory-dances in the end zone should come as no surprise. This is the kind of behaviour we should expect at the top.
The Greatest Short Squeeze of all time
The Market Gods are not a lenient bunch. They have a way of knocking down the cockiest amongst us.
I find it ironic that investors are embracing the idea that Central Bank buying will keep propelling financial assets higher at the very moment that these flows are set to decline.
I am not some doomsdayer who thinks the world must implode in some deflationary collapse to cleanse the financial system of our over-indebted sins.
Yet I am a realist who understands that markets go too far one way, and when that happens, they inevitably correct, and right the ship.
There is no doubt in my mind that too many investors have abandoned fundamental analysis, and in one of the greatest short squeezes of all time, have piled into financial assets at the worst possible moment. They are not buying because assets are cheap, but instead because they are going up.
Markets are always changing - change with it.
Instead of complaining, true long term value investors should be welcoming this mad scramble. It is sowing the seeds for the next opportunity.
So yeah, fully invested passive index investors might be having laughs at our expense right now, but as Harry Hogge used to tell Cole Trickle, “he didn’t slam you, he didn’t bump you, he didn’t nudge you… he rubbed you. And rubbin, son, is racin’.”
No sense getting all sanctimonious about either side. For sure - ETFs and passive investing is way, way too popular right now. Just like my story of the triple witching expiry, there will be an event that catches market participants off guard. Then fundamental investors will step in and correct the mis-pricing.
Too much indexing will be self-defeating. Indexers should never, ever, laugh at fundamental investors as they are essential to their survival. But neither should fundamental investors treat ETFs like the scourge of the world.
The famous recluse trader Ed Seykota once said, “the markets are the same now as they were five or ten years ago because they keep changing - just like they did then.” Ed is spot on.
Markets are always changing. Debating about it is like arguing with the wind.
Rather than digging my heels in on some philosophical debate about the best direction for markets, I prefer to attempt to figure out where it is heading, irrespective of my opinion of where it should go. I have nothing against fully invested passive strategies - at the right time. But I beg to differ that fundamental analysis never works and that you should simply lap up whatever returns the market returns you regardless of valuations. I feel like there has never been a worse time to just blindly clasp this sort of strategy.
We are on a cusp of a major turning point, and active managers are about to have their day in the sun. Here is my prediction. Within the next year the hedge fund manager will be able to return the favour to the over-confident passive money manager.
And I will leave you with some immortal words from legendary strategist Bob Farell:
- Markets tend to return to the mean over time.
- Excesses in one direction will lead to an opposite excess in the other direction.
- There are no new eras - excesses are never permanent.
- Exponential rapidly rising or falling market usually go further than you think, but they do not correct by going sideways.
- The public buys the most at the top and the least at the bottom.
I wonder what Bob would say about the current group of exultant passive money managers?