The Nightmare Scenario: JPMorgan Warns Of $7.4 Trillion In ETF Selling During Next Downturn

When it comes to sleepless night involving the great unknowns locked in the Pandora's box that was created by central bankers and which will be unleashed during next financial crisis, one nightmare is among the most recurring: what happens when the ETFs, which have been buying stocks for the past decade, begin to sell?

The answer, according to JPMorgan, would be nothing short of catastrophic.

According to a new report from JPM equity strategist, Eduardo Lecubarri, passive investing (i.e., ETFs and index funds) - which was not a big driver of equity returns in the last recession as it accounted for less than 30% of the AUM in actively managed funds back then, "should bring big selling pressure to large caps and US small and mid caps during the next downturn", Lechubarri writes, as a result of the staggering increase in Passive AUM over the past decade which, as a % of active AUM, has nearly reached parity, and was around 83% as of 2018; Passive AUM is widely expected to surpass Active AUM over the next two years.

How much selling pressure? JPMorgan calculates that some $7.4 trillion in stocks would be subject to forced selling by passive funds during the next downturn.

"This is something worth noting at this late stage of a cycle given that passive investing seems to be trend following, with inflows pushing equities higher during bull markets, and outflows likely to magnify their fall during corrections" Lechubarri warns.

Lecubarri also notes that passive investing is far more skewed to Large-Caps than what their market caps would command, "making this asset class far more exposed to momentum selling during market downturns."

So what does JPM do with this information? Simple: it tells clients to sell all those names, industries and geographic regions which are overexposed to passive investors:

We find Real Estate, Telecom, Utilities, Financials, and Industrials are most exposed to passive investing within US SMid-Caps, while Healthcare and Energy are the most clear safe havens. As for SMid outside the US, all sector exposure to passive investing is within a tight range, and thus unlikely to be a key driver of relative returns.

Of course, while JPM may have come up with some hiding places ahead of the ETF liquidation deluge, the truth is that if and when some $7.4 trillion in selling starts without central bank backstops to soak it all up, there will be no place to hide.