JPM Warns Shift To Passive Investing Increases Systemic Risk, Will Make Crashes Worse
After nearly a decade of central planning by global monetary authorities, the hedge fund industry has found itself unable to generate any alpha since 2011. As Barclays recently calculated, the average monthly alpha has declined to -0.07% (annualized ~0.8%) from 2011 to May 2016 compared to an average of +0.48% (-5.9% annualized) for the entire period analysed (1993 to May 2016).
This has resulted in not only formerly respected hedge fund managers like Bill Ackman (as well as countless more) being forced to revise the traditional 2 and 20 fee structure to retain fleeing clients, but also the biggest outflow from active managed funds on record, as inflows into passive, ETF-based asset managers continue unabated.
This unprecedented shift in capital away from active managers and toward passive strategies has resulted in not only a chilling effect on the hedge fund industry, culminating with the fewest hedge fund launches since 2000, and massive redemptions, creating a feedback loop which assures even lower returns in the future and even more pain for the “2 and 20” crowd…
… but also concerns about a market in which “passive”, robotic, algo-driven decision makers are the marginal buyers and sellers of securities.
And while it is the case that so far, the market has been spared an observation of how a largely passive investing crowd would respond during a downturn (and more importantly what happens to market liquidity), the time is drawing nearer with every passing day, and certainly as central bankers collectively try to prop up global yield curves.
So what are the implications from this shift toward passive investing?
Conveniently, that is the topic of the latest Flows and Liquidity piece from JPM’s Nikolaos Panagirtzoglou, in which he makes some interesting and troubling observations, of which three are key:
- Markets become more brittle, risky: “The shift towards passive funds has the potential to concentrate investments to a few large products. This concentration potentially increases systemic risk making markets more susceptible to the flows of a few large passive products.”
- Crashes, when they happen, will be bigger and badder: “the shift towards passive funds tends to intensify following periods of strong market performance as active managers underperform in such periods of strong market performance. In turn, this shift exacerbates the market uptrend creating more protracted periods of low volatility and momentum. When markets eventually reverse, the correction becomes deeper and volatility rises as money flows away from passive funds back towards active managers who tend to outperform in periods of weak market performance.“
- Markets become less efficient: “if passive investing becomes too big, potentially crowding out skilled active managers also, market efficiency would start declining. In turn, this would present opportunities for active managers to extract arbitrage profits.”
Here are his thoughts:
The rise of passive funds at the expense of active funds has been well documented and has attracted widespread attention in the press recently. Figure 1 shows that the shift towards passive funds has been a trend that started before the Lehman crisis but intensified after the Lehman crisis. In fact after the Lehman crisis the trend towards passive investing has been boosted by the explosive growth of ETFs, the AUM of which currently stands at $1.8tr, from $0.5tr before the Lehman crisis, i.e. the ETF universe more than tripled since the Lehman crisis. For comparison, the AUM of mutual funds worldwide grew 53% over the same period.
The shift towards passive investing has accelerated over the past two years. This is shown in Figure 2 which shows the cumulative flows into passive and active equity and bond funds domiciled in the US. Since 2014, active mutual funds have been experiencing outright outflows.
Figure 3 and Figure 4 also show that the shift from active to passive investing appears a lot more advanced in the equity fund vs bond fund space. For example, active equity mutual funds started experiencing outright outflows after the Lehman crisis in the US and these outflows intensified after 2014. Active bond mutual funds started experiencing outright outflows more recently after the taper tantrum of 2013
What are the implications of the shift towards passive funds?
- 1) End investors such as retail investors are becoming more important in driving markets. Swings in retail investor sentiment, which are often abrupt due to typically shorter investment horizons than institutional investors, are transmitted into markets more quickly as the cushion from active managers accommodating retail investor flows is removed. For example, if retail investors turn suddenly bearish and decide to withdraw a lot of previously invested active funds from the market, active managers could accommodate this selling pressure by running down their cash balances. In this way, the bearishness of retail investors is transmitted less abruptly to markets relative to the case where retail investors withdraw their money from passive funds that hold no cash balances. In other words, active managers inject a degree of convexity to markets which would naturally diminish if passive investing becomes even more dominant in the future.
- 2) Markets could see more protracted momentum periods coupled with deeper corrections. Markets would see more protracted uptrends to the extent that there is more herding in retail investors’ behaviour. In addition, the shift towards passive funds tends to intensify following periods of strong market performance as active managers underperform in such periods of strong market performance. In turn, this shift exacerbates the market uptrend creating more protracted periods of low volatility and momentum. When markets eventually reverse, the correction becomes deeper and volatility rises as money flows away from passive funds back towards active managers who tend to outperform in periods of weak market performance.
- 3) The shift towards passive funds has the potential to concentrate investments to a few large products. In turn, asset concentration potentially increases systemic risk making markets more susceptible to the flows of a few large passive products.
- 4) Passive or index investing favours large caps as most equity indices are market cap weighted. This could exacerbate the flow into large companies beyond to what is justified by fundamentals, creating potential misallocation of capital away from smaller companies. To the extent that these passive funds become even more dominant in the future, the risk of bubbles being formed in large companies, at the same time crowding out investments from smaller firms, would significantly increase.
- 5) The proliferation of index funds increases the size of stock inclusion flows. In turn, market moves around index constituent changes become more pronounced overpenalizing companies leaving the index and causing excessive gains to companies entering the index.
- 6) Passive investing potentially reduces corporate activism. The conventional wisdom is that passive owners will show little interest to corporate governance relative to active managers and as a result corporate activism would naturally decline. But there is little empirically evidence of that happening. Gormley , Keim and Appel showed in their academic work show that mutual fund firms which focus on passive investing do indeed cast their shareholder votes to press for change, and do it effectively. In addition, they show how passive investing also leads to more aggressive shareholder activism than there would be otherwise, as passive fund firms add their clout to campaigns waged by activist investors.
- 7) Passive investing potentially reduces market efficiency. This is again the conventional wisdom but we believe that this argument is not entirely correct and could be valid only after the shift away from active towards passive funds becomes more advanced. Initially the opposite could be argued. It could be argued that the shift away from low skilled active managers to passive investing could increase market efficiency as the noise from low skilled managers is reduced. But if passive investing becomes too big, potentially crowding out skilled active managers also, market efficiency would start declining. In turn, this would present opportunities for active managers to extract arbitrage profits. In other words, if passive investing becomes too big, the portion of active managers outperforming the market would naturally rise and the flow would start shifting again away from passive towards active funds. So there is a natural limit of how high passive investing can grow at the expense of active managers. How high this natural limit is not yet clear. At the moment, there is little evidence of active managers generating enough alpha even as the share of passive funds has grown steadily nearly 30% in the US. In addition, the HF industry has been failing to generate alpha in recent years with little evidence of succeeding to do this so far this year as shown in Figure 5.
In all, this suggests that there is more room for passive investing to grow over the coming years at the expense of active managers until more low skilled active managers are removed from the marketplace and market inefficiencies start emerging for the skilled ones.
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And then, just in case hedge funders’ lives were not bad enough, JPM decided to remind them that “HFs are failing to produce alpha for another year.“
Hedge funds have produced lackluster performance this year. The performance of HFs was not only poor in absolute terms but also relative to a traditional bond/equity portfolio benchmark. In particular, relative to a bond/equity portfolio benchmark, with weights chosen to reflect the relative distance of bond and equity volatility from that of HFs, HFs underperformed by 2.2% in 2016. According to Figure 5 this negative “alpha” in 2016 was worse than the -1.6% seen in 2015, but better than the -5.0% seen in 2014. But it is still disappointing given the failure of the HF industry to achieve positive alpha for three consecutive years. And before 2013, one needs to go back to 2010 for another positive alpha. Similarly in terms of flows, Figure 6 shows that the HF outflows over the past year are the worst since the Lehman crisis.
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While this is bad news for hedge funds everywhere, who are likely to suffer even greater AUM declines, and even lower fees, it may all change overnight should central banks – the entities whose only true mandate has been to be the market’s Chief Risk Officers since 2009 and not allow even the smallest downturn – lose control and “make hedging great again.” Then again, it may be too late: if there is another market crash, it is possible that what little faith and confidence in the market remained, is gone for ever. That said, with some of the smartest people around forced to engage in socially productive activities for a change instead of just creating ever more debt, there could be worse outcomes.