Vexing Today’s Convex Pricing Behavior

After getting into our offices around 8:30 am Eastern on Monday morning, I was lucky enough to catch an interview with famed short-seller Carson Block of Muddy Waters. As expected, CNBC anchor Andrew Ross Sorkin asked about GameStop and short sellers. Block provided his answer, but then went on to say:

…But the bigger issue really is that when you get down to what actually causes this. I’m going to throw something out there that I suspect a vast majority of your listeners have not heard, but a lot of this disfunction is being driven by the prevalence of passive investing. I want to say one thing before questions come my way. Yes, I knew about the robo-bid and I knew that fundamentals are irrelevant to the robo-bid or passive investors. What I didn’t appreciate is that as passive grows in a float that It actually creates convex pricing behavior. It basically becomes the driver of growth and it is in my mind, based on my understanding now, it’s the single biggest explanation for why growth as a style has massively outperformed value. Again, it’s not tied to fundamentals. It’s tied to supply and demand.

His use of the word convex is interesting because convexity is typically only discussed with bonds. As bond yields fall, convexity explains the underestimation of bond prices from a linear view. The inverse is true as well, causing a curvature of bond pricing relative to a linear relationship of bond prices and bond yields. To simplify this, convexity explains how bond prices increase in a more rapid fashion as yields fall. In fact, zero-coupon bonds that only pay interest upon maturity exhibit the most rapid increases (high convexity) in price as bond yields fall.

However, Carson was not trying to teach us about bond yields and pricing in his use of the word convex. He was explaining that the planned buying among passive participants is causing a similar curvature. Planned buying would happen among 401(k) plans, high-income savers, and wealthy business owners automatically investing into the equity markets. These types of investors have continued to gravitate their investments from a price-sensitive investment vehicle (active) to a price inelastic vehicle (passive). Passive was a small part of the stock market 20 years ago, with only folks like Vanguard, Motley Fool, and William Sharpe peddling the idea. The lack of size allowed these early adopters to benefit as they were a small part of the total float of the stock market and individual securities, to Block’s point.

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