Passive Investing’s Dirty Little Secret: It’s All Good, Until It Isn’t

Shah Gilani|April 20, 2020

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Editor’s Note: “Passive investing” is one of Wall Street’s dirtiest secrets and one that can easily wreck your portfolio if you’re not prepared. Nobody lays that bare better than my good friend and colleague, Shah Gilani. Shah and I have known each other for more than 20 years and I think you’re going to find his thinking quite compelling, especially given today’s 350 swing despite a crash in oil prices.

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Dear Reader,

The secret momentum driver elevating market indexes to all-time highs, again and again, is none-other than the “passive investing” trend. It’s going on unbeknownst to even the drivers of this momentum bus.

Investors who don’t understand how big an impact money flowing into index funds has had on the market’s performance probably have no idea what could happen if the trend stalls, or worse, reverses.

Here are the pitfalls of passive investing and how bad the fallout could be if passive investors discover the trap they’ve entered, turn active, and sell.

The almost self-perpetuating cycle of rising markets attracting passive investment capital into index products, which boosts the value of indexes as money flows into them, which attracts more sidelined money and compels investors to sell actively managed funds and buy passive index-following funds, which have been lowering their management fees since they aren’t actively managed, which attracts more investor capital into the growing universe of index funds, which keep increasing in value as sponsors and their authorized participants buy all the underlying stocks in the indexes they track when investors buy those packaged products in the open market, is, almost self-perpetuating.

But you know the saying, almost only counts in horseshoes and hand grenades.

The truth is passive investing’s virtuous positive momentum manufacturing feedback loop isn’t a guarantee.

What passive investors aren’t seeing, because they aren’t looking through or behind the mad rush into what looks like a better mouse trap, is that more money flowing into index funds increases systemic risks inherent in the investment.

Risks behind the curtain.

First of all, it’s the extraordinary amount of money flowing into index funds that’s inflating the value of those indexes. Passive investors, small and medium fund sponsors, giant asset management companies like BlackRock, Vanguard and State Street who dominate the index products business, and regulators, either don’t think or don’t want to think that this is true.

As the market goes higher and higher, passive investing returns trounce actively managed funds’ performance, and passive investors think that there is less perceived risk. As this happens, the index-following crowd becomes less concerned about company and stock fundamentals. Instead, they foolishly rely on rising markets as a kind of ratings approval of their investment vehicles.

The dangerous truth is that index funds aren’t rated and investors aren’t doing homework or analysis on their investments. The rising market, which they’re very much responsible for, is their rating system stamp of approval.

That reminds me of the insane build-up in the value of mortgages and mortgage-backed securities. Homebuyers and investors who saw rising home prices stopped doing their homework on what was causing the rise. Instead they relied on cheerleading rating agencies’ rubberstamped investment grade ratings. Even junk tranches of structured layers of crap were given a thin wrapping of AAA brown paper.

The fallacy that passive investing is less risky than investing in the market (yeah, some people actually believe that) is based on the rise of passive investing over the past ten years coinciding with the market’s extraordinary rise…over the past ten years. See where this is going?

Index funds as a “safe-haven.”

It gets worse. The stock market, meaning benchmark indexes, has gone higher after every big and little bump over the past ten years. It has recovered quickly when bumped by anything. That means that passive investors are looking at indexed funds as safe-haven trades in times of trouble.

They’re right to believe that the Federal Reserve “writes options on the market for investors.” We saw this in the Greenspan put, the Bernanke put, the Yellen put and now the Powell put. However, those puts didn’t stop equity markets from scary drops.

Yes, they always recovered quickly every time they dropped, but that doesn’t make index funds safe-haven vehicles.

The latest proof of the index-fund as a safe-haven trade was evident in December 2018. On the heels of the market’s trouncing, which started in October, investors pulled $143 billion out of actively managed funds in December, a record amount, and bought $60 billion of index funds.

Full theaters with crowded exits.

What the swelling passive investing crowd doesn’t see is that they’re all crowded into the same theater, watching and cheering the same play.

They don’t realize that they’re all increasingly over-weighted in the handful of big-cap weighted stocks that draw the most capital from investments made in indexes with even as many as 500 stocks.

They don’t realize that institutional investors, hedge funds, and big traders jump into those same big-cap, hyper performing stocks. They don’t just do this to ride the momentum created by passive investors, but also to push them up to inflate indexes that they dominate. This draws in more passive investors, generating still more momentum.

It’s all good, until it isn’t.

The singular most powerful driver of the market’s incessant rise, since the beginning, going back to the origin of the bull market starting in 2009, has been the Fed’s artificially manipulated low interest rate environment. The passive investing momentum-manufacturing machinery driving markets higher over the past few years is added fuel.

What if rates rise? Will that kill the passive investing momentum machine like it did in 2018, when the Fed raised rates three times? Probably.

What if the economy falls into a recession? Will passive investors, who’ve never seen a recession since the trend exploded, question whether they’re overly exposed to something that always knocks the stock market down? Probably.

What if older investors who’ve plowed retirement money into index funds, into the market, when they traditionally would be reducing their exposure to equities, see the market falter and rush for the exits? Will investor “rebalancing” slow or stall the momentum machine? Probably.

What if so-called passive investors start to put down stops on their positions? What if they already have? Will any unexpected pullback trigger stops, which could drive the market lower, which could cause more investors to put in more stops, which could get triggered, and result in rolling stops getting hit, taking the market down in frightening fashion? Probably.

What if authorized participants, the market-makers responsible for buying all the stocks underlying all the index funds when investors buy units of those funds, have to sell all the underlying stocks in those funds when investors sell their units, get ahead of investor selling by shorting all the stocks they know they’re going to have to sell as they see passive investors’ sell orders pile up? Will that knock stocks down and trigger a rolling hit? Probably.

What’s probable is at least possible.

Passive investors, fund sponsors, market analysts and regulators need to wake up.

Index funds aren’t a one-way ticket to higher markets.

They’re good for rising markets, as long as markets are rising from passive investing money flows.

In fact, it’s all good. Until it isn’t.

Sincerely,

Shah