“…what happens if this trend reverses?”

It was back on February 17^th when Marketwatch had a story titled “Here’s why you shouldn’t buy a stock ever again.” I highlighted this in a note last month as the flood of index money was coming in post election. If there was ever a story that should have alerted any stock market contrarian it was that one and just maybe we had reached peak obsession with passive/low fee investing. I initially read the article as a sign that a trend change in investing style was upon us. It wasn’t until a tweet from my friend Gary Kaminsky yesterday that I began to think about the consequences from a broader market/macro perspective. He wrote:

It’s going to be interesting to watch how all that money that went into index funds the last three months behaves in any ordinary pullback

— gary kaminsky (@GaryKaminsky) March 27, 2017

It’s a great point to raise that what happens if this trend reverses? Combine this with all the algos and trend following systems and are we in the midst of modern day portfolio insurance?

I then read an article in the weekend’s Financial Times titled “The eventual decline in asset values will be catastrophic…The mania for average returns has been suppressing short term losses, or corrections” by John Dizzard. The article started by saying:

We have created a bubble in average. Waiters and childhood friends are no longer telling us about what miracle gold, oil, or tech stocks they bought at the right time. They are exchanging stories about low management fees on their index-tracking exchange traded funds. This sounds like the warning bell at the top of a mania. Only now it is a mania in low transaction costs, average returns, and on-demand liquidity.

It went on to compare this behavior as a form of momentum investing, no different than what some technical trading professionals do.

As to Gary’s point, the article said:

Index-based investment management, more sophisticated algorithmic trading, and even slow and steady buy-on-the-dips retail investing have all been suppressing short term losses, or corrections. Short term asset price declines have been reversed by the wall of money coming out of active investment managers and into the accounts of low-cost index products. But this comes at the expense of making the eventual decline in a broad range of asset values not just painful, but catastrophic.

I’ll finally add a CNBC Pro article written over the weekend by another friend Michael Santoli who talked about the passive vs active debate and the difficulty of stock pickers in outperforming.  We all know the pressure on stock picking relative to indexing and he said:

So good luck reading the press release, listening to the conference call and plugging in next year’s consensus earnings forecast to beat the machines.

He did follow with what I believe to be soon upon us:

There’s a growing argument that the fashion for owning the index and using quant tools is setting the stage for its own demise, that so many dollars willfully ignoring traditional fundamental analysis and sleuthing will re-open an opportunity for stock pickers.

To quantify the portfolio shifts, he cited this:

In a report last week, global strategists at Citi noted that there’s been nearly a trillion-dollar worldwide swing from active to passive funds in the past 12 months, according to fund tracking firm EPFR. Some $542 billion entered index funds while $442 billion departed active portfolios.

Here was the chart he published:

Bottom line, I believe we’ve reached peak passive investing. Of course it can stay at a high level for a time to come but this sort of behavior historically happens at the end of a cycle. It is important to add though as stated above that what follows is not just a change potentially in investing styles but will it be a rush for the passive exits and a sharp market decline that cause that change? What will the average investor say when their index fund is down 10% or even 20%? I’m sure they will be encouraged to hold tight and buy more. I remember that same conversation in 1999. That is a fine strategy for those investors with a time horizon north of 10 years, as long as they don’t panic when that 10% decline becomes something much deeper. In fact, bear markets are long term investors best friend but only if they have the fortitude to do what most others don’t do and that is to keep one’s cool and buy. Or, as human nature never changes, will the passive rush panic on the downside just as they are doing so on the upside? Vanguard said they are getting $1 billion per day in index money.