If Passive Investors Turn Active Expect A Crash

Shah Gilani|January 4, 2019

Back in October, JPMorgan Chase & Co. (NYSE:JPM) analysts Eduardo Lecubarri and Nishchay Dayal warned that $7.4 trillion of global assets managed in passive funds could exacerbate a rout the next recession.

They were wrong, but at the same time, they were right.

We’re not in a recession.

But, the escalating selloff is weighing heavily on passive investors, especially in the highflying big-cap stocks that led indexes and index funds higher for ten years.

That means passive investors are losing money and could turn seriously active any day now.

If that happens, a crash may not be far behind – and we’re getting close to market levels that could trigger active selling by passive investors.

So, listen up: Here are the numbers that matter, what they’re telling us, and what you can do to protect yourself…

Numbers Don’t Lie

In their October report, Lecubarri and Nishchay said, “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.”

The bank’s analysis shows in 2007 money in passive funds amounted to about 26 percent of actively managed large- and all-cap funds’ assets in the U.S., and 15 percent outside the U.S. “Eleven years later those figures have jumped to 83 percent and 53 percent, respectively,” according to the analysts.

JPMorgan’s report also notes that passive investing and passive investment funds are far “more skewed to large-caps than what their market caps would command, with passive assets under management in large-caps 10 times that of small- and mid-caps, making this asset class far more exposed to momentum selling during market downturns.”

While we’re not seeing outflows from passive funds yet, inflows slowed dramatically in 2018 and investors in passive funds are now opening their fourth quarter statements and seeing losses.

There are trillions of dollars parked in passive funds in the U.S.

According to the Wall Street Journal, assets under management in U.S. equity index funds (index funds track benchmark and proprietary indexes and aren’t actively managed) totals $4.6 trillion.

70% of those assets under management (AUM) are invested in the broad market, mostly big-cap stock indexes modeled after the Vanguard 500 Index Fund.

The Vanguard Group, under famed mutual fund innovator and founder John Bogle, launched the first broad market index mutual fund in 1975. Now the largest mutual fund in the world with more than $726 billion AUM, known as the Vanguard Total Stock Market Index (VTSMX), it runs the $441 billion AUM Vanguard S&P 500 ETF (NYSEArca:VOO), has more than $5 trillion under management.

Vanguard itself holds 51% of assets parked in passive funds in the U.S.

BlackRock Inc. (NYSE:BLK), the largest investment manager in the world with more than $6 trillion in AUM, has a 21% share of assets in passive funds in the U.S.

Rounding out the top three passive funds purveyors, who together control 81% of the market for index fund products, is State Street Global Advisors, owned by State Street Corp. (NYSE:STT). State Street has 9% of the index fund products market and more than $3 trillion in AUM.

While Vanguard is owned by the funds it manages and shareholders of the funds, in turn, own them, BlackRock and State Street are publicly traded companies.

Both have seen their stock prices pummeled as inflows into their fund complexes slowed dramatically in 2018.

BLK, which traded at an all-time high of $594.52 in January 2018, traded as low as $360.70 a few trading sessions ago, down 39% in a year.

STT saw an all-time high of $114.27 last January and traded down to $56.40 in December. That’s a 49% pounding.

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Since passive investors are increasingly shifting assets out of mutual fund products and into ETF products, because they can be traded all day, every day the markets are open, it’s instructive to note the dramatic slowdown of inflows into ETFs from 2017 to 2018.

U.S.-listed ETFs saw inflows totaling $476.1 billion in 2017, according to Morningstar.

In 2018, up to and through November 30th, inflows totaled $309 billion. Final net flows for December haven’t been published yet.

That’s a 35% decrease year over year, not including what might have flowed into funds in December, the worst December for stocks since 1931.

It doesn’t take a rocket scientist to figure that with the Dow Jones Industrial Average (a big-cap index) trading on average just below 25,000 in 2018, and reaching an all-time high of 26,951 in October, passive investors who poured money into index funds in 2018 are underwater with the Dow currently at 23,384.77.

Back of the envelope math indicates that’s about an 8.4% loss to date.

What happens if those passive investors see the Dow take out the new lows it made less than two weeks ago?

Will they panic? Will they become “active?”

What about the hundreds of billions of dollars that flowed into passive index funds in 2017 as the market was making new high after new high?

Those investors, if they were late to get on board the nine-year momentum train, got in somewhere on average in 2017 when the Dow was around 22,000.

What happens to them if the Dow falls back there?

It closed at 22,686.22 yesterday; that’s only 0.97% from 22,000.

Will they panic? Will they become active?

If passive index fund buyers over the past two years turn active in the event the Dow breaks important support at 22,000, there could be a trillion and a half dollars’ worth of stock for sale in about a New York minute.

That selling would beget margin calls and more selling. That’s when the market could crash.

An Opportunity of a Generation

I’m not saying we’ll get there, or that passive investors will panic and turn active.

There’s always a chance they could average down and buy into any panic selling, like trying to catch a falling knife.

Unfortunately, I don’t think passive investors are that well trained, that calm, that sure of the markets bouncing back if they’re suddenly sitting on 25%-50% losses in their retirement and retail accounts.

Maybe I’m wrong.

If I’m not, and there’s a crash, it’s going to be the buying opportunity of a generation.

It’s going to make the dive in 2008 look like a slog, because it took the market five and a half years to get back to its old highs.

If we get a crash this time, however low we go, it will take less than two and a half years for the market to double from its lows.

That’s because there are fewer shares of stocks in the market today than there were in 2008, thanks to trillions of dollars in buybacks and mergers and acquisitions, and $11 trillion more in capital globally today (because central banks printed that much) to bid those shares back up.

And, if the market crashes, central banks will do what they have to do again, which worked out beautifully for equity investors.

Everything’s changed; the overriding bullish sentiment that powered markets higher for nine years has finally died.

In the event of a crash, you need to be serious about protecting your assets. Because if the massive swings between highs and lows didn’t freak you out in October and November, they should.

If the bull market wheezing out the last of the air in its lungs over a three-month period didn’t make you think about the future of your investments, your 401(k), or your retirement, it should.

When a crash comes, no one’s going to be there to protect you but you – so you need to act now, and I’ll tell you exactly what you should do.

After years of research, my friend and colleague, Chief Investment Strategist Keith Fitz-Gerald, has released a step-by-step guide, a Market Crash Survivor’s Guide, if you will.

In this guide, he’ll tell you everything you need to do to make sure that you won’t suffer along with everyone else when the crash comes.

And it’ll come.

Click here to learn more.

Sincerely,

Shah