Exploiting “Passive” Aggressive Behavior

So everybody knows the combination of central bank largesse and the rampant proliferation of low-cost, passive investment vehicles killed active management. When benchmarks are being bid constantly higher and the cost to replicate those benchmarks is 10bps, you have no business model if you’re in active management. Period.

The problem of course is that retail investors don’t appreciate the extent to which their returns since 2009 are almost entirely attributable to trillions in central bank asset purchases.

Every would-be guru and newsletter purveyor thinks it’s a complete coincidence that the active management community just happened to become “stupid” at the exact same time the coordinated, global effort to inflate benchmarks got underway:

(Goldman)

Of course this will all come crashing down at some point. Right now it’s unclear what the catalyst will ultimately be, but you can rest assured that ETFs/ETPs and the distortions they create will play a role.

Maybe then active managers can salvage something in terms of AUM out of the ashes of an obliterated market. Who knows.

Until the day of reckoning finally comes, it’s worth asking if the distortions created by passive investing themselves create opportunities for active managers.

That is, is it possible that the tables can be turned here and that active managers can identify exploitable anomalies emanating from the epochal shift to laissez-faire investing?

Well, Citi decided to investigate. Read below as the bank takes a fresh look at a “passive” aggressive behavior.

Via Citi

EPFR data suggest that in the past 12 months global active managers have suffered $538bn outflows while passive funds have seen $488bn inflows (Figure 2).

This raises many questions about passive market share. How big is it now? How much bigger could it get? Has it created market distortions which could be exploited by active managers?

We went to the usual data sources to answer these questions. Morningstar suggest passive has risen to 42% in the US (Figure 3).

Another source of this ‘passive market share’ data is EPFR (Figure 4). They show similar market share figures to Morningstar for the US and Europe, although their Japan figure is way up at 72%. Outside some apparent data-sampling issues in Asia, these figures are widely published in the financial press.c40% of the US institutional and retail money sampled by Morningstar or EPFR is now passive. That number is still rising. It clearly represents a major challenge for the active fund management industry. US asset manager shares are underperforming despite the bull market tailwind. Imagine how bad it could get if we had a bear market.

Nobody denies that the rise of passive investing is bad for the active fund management industry, but does it also represent an opportunity? Surely 40%+ market share will create distortions that could be exploited.

This is where we have to be careful. Maybe 40% of the US retail and/or institutional savings industry has shifted to passive. But that doesn’t mean that 40% of the US equity market is now owned by passive funds.

We looked at the shareholder lists of major listed companies around the world to aggregate the shareholders of passive investors. We then compared these to the free floats (ie the investable universe) as defined by MSCI. This gave us the country rankings shown in Figure 5.

Passive investors own 22% of the US MSCI free float, with the UK next at 16%. These figures are much lower than the ‘passive owns 40% of the US market’ often quoted back to us. This has important implications for the debate about whether passive ownership is now big enough to create market distortions – 40% is much more than 22%.

Maybe this explains why it’s difficult to find evidence of major market distortions created by the rise of passive investing. Figure 7, from our quant team, shows pairwise correlations across the world. The recent accelerated shift into passive investing, especially in the US, has been accompanied by falling correlations. If enormous indiscriminate buying and ownership by passive investors really were the distorting markets, we would expect to see much higher correlations.

 

 

We can see some signs of distortions when we look at stock performance around inclusion in important indices tracked by passive funds. For example, Figure 8 looks at stock performance around S&P 500 constituent announcements. New index entrants tend to outperform as inclusion is announced, perhaps reflecting that speculators are anticipating big buy orders from S&P trackers. These stocks continue to outperform just after announcement. There is then usually another burst of outperformance around the inclusion date one week later.

The overall message is that passive ownership of global stock markets is not yet as high as some might think. Maybe this is why the exploitable distortions remain limited.

So that’s all very interesting, but it misses a number of important points and lacks any semblance of nuance.

It’s Saturday so we’re not going to subject you to a diatribe, but note that Citi’s definition of “exploitable” isn’t ambitious enough.

After all, we know that the rise of passive has created all manner of distortions. If all you’re looking at is discrete trading signals around things like index inclusion when you define “exploitable”, then maybe opportunities are indeed “limited.” But if you think about the giant dislocations that ETFs are creating and the rickety creation/destruction mechanism that underpins them as a massive opportunity to place bets on a black swan event for pennies on the dollar, well then the epochal shift to passive is about as “exploitable” as “exploitable” gets.