The troubling swings of US markets during September illustrated how sensitive they are becoming to political and trade turmoil. It is the latest of several indications over the course of the last twelve months that exhibited high levels of sensitivity and sporadic bursts of volatility. Such an observation begs examination as to why this is occurring and what might this mean for the future, particularly as the bets increase that a change of cycle is imminent.
Where to Look for an Answer?
There are many standard plausible explanations for what we are seeing in the market. Examining what is unusual or new in the scenario requires a more intensive look. It is there, more than likely, that the unknowns and unforeseen problems will begin incubation.
Spot the Difference
What is the most significant change that has taken place since the financial crisis of 2008 from an investment management perspective? We would conclude that it is the overwhelming change in the way in which money is being managed. The marked lack of expansion in US equities during a time of unparalleled growth has been accompanied by the explosive increase in funds being invested passively rather than actively.
The Nature of Investing
With passive investment now constituting over half the value of all US equities investing, questions have to be asked about the potential distortion this scale of inactivity might generate.
Perhaps a useful analogy for US equities investing is to think of it as a forest ecosystem. This ecosystem is experiencing a significant shift, as things are moving from what could be considered stock picking to stock replication. Traditional stock picking—for all of its flaws and perhaps very much because of its flaws—served as an important layer of the market’s ecosystem as a way to filter to some extent, the good from the bad, the large from the small. This active trading could be thought of as undergrowth on the forest floor in constant flux building up and being cleared back through the investment activity of buying and selling.
Passive investment in a way, is as though half of this flux has been stopped and the undergrowth is no longer being tended, thus it is growing and growing unchecked. Think about and imagine the potential unforeseeable dangers. A new and possibly unnatural balance is being established. Instead of there being a multiplicity of different competing investment horizons, there are singular monolithic investment outlooks (regardless of whether that was the individual investor’s intention) with a pre-disposition for only one consideration to take place. Investors expect to see ascending price over the long-term. Back to the forest—with unchecked undergrowth building to previously unknown levels—what if there is a fire?
The marketplace’s traditional function was to establish ‘fair value’ based on supply and demand. That mandate is now skewed. In the past, the same function that over time came to rely on fundamentals to provide the necessary information on which to form the basis of ‘fair value’ and then on a healthy degree of buying and selling to determine price. Times change.
Enter the Guaranteed Buyers
As replicators, the passive index funds must buy in proportion to their basis index. Thus, half of all floating shares are being bought and sold with no further reference to anything other than percentage composition of an index. On the other-hand, the most important indices – are still operating in pre passive investment mode, where market capitalization is calculated as price times the number of floating shares. The only thing is that price in the old sense of fair value is now only being determined by half of the participants, with the other half following.
This relationship is not quite as simple as the statement above would suggest. Things are further complicated by the inherent bias towards higher price that the replication has and furthermore by the nature in particular of a market capitalization index to feed the winners.
The effect is that increased replication draws price upward, away from what could be called the fundamentally-based price. Hence it may be necessary to consider a non-fundamental price formation, due to passive investment.
With powerful passive-index investing illustrations of 600% returns over 25 years, passive investment can be thought of as being a vehicle for the storage of national wealth. This is not something to be ignored or lightly dismissed. Hence protecting the continued growth of US equities indices themselves, could well tend towards being a matter of national concern. Have we begun to see the first signs of this policy phenomenon, with index-bolstering interest-rate decisions perhaps influenced by the fear that an index is something that is truly too big to fail?
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