Last summer, Howard Marks made waves by poking two hornet’s nests at once in a sweeping memo to Oaktree clients called “There They Go Again … Again“.
In that note, Marks warned against the tendency for investors to implicitly assume they can see the future by betting the house on a handful of high- flying stocks (in this case FANG, or some derivation of that acronym) and also expressed reservations about the long-term viability of the “perpetual motion machine” dynamic facilitated and perpetuated by the proliferation of passive investing and ETFs.
Regular readers know I’m fond of quoting Marks on all manner of issues and it’s worth noting that another of his famous critiques (the liquidity mismatch inherent in high yield and emerging market debt ETFs) is becoming more relevant by the week as emerging market bonds continue to suffer as the Fed tightens policy.
The timing of Marks’ summer 2017 memo was fortuitous as it came just six weeks after Goldman’s infamous “Is FANG Mispriced?” note. In that piece, the bank made an argument that was not at all dissimilar from what Marks suggested. Specifically, Goldman warned that, through no fault of their own, tech stocks were becoming synonymous with multiple criteria that inform factor-based strategies. That, in turn, sets the stage for factor-crowding. Here, for those who need a refresher, are the key passages from that Goldman note:
While not exactly a Fields Medal worthy observation, we note that FAAMG is positively correlated with Growth and Momentum and this relationship has strengthened in recent months. The bigger anomaly, however, is that FAAMG is almost as highly correlated with Low Vol (as measured by standard deviation of 1Y daily price returns), which is not a characteristic typically associated with cyclically driven TMT names.
If FAAMG was its own sector, it would screen as having the lowest realized volatility in the market. How can low vol create a problem? Investors are increasingly focused on “volatility-adjusted” returns as they are deciding which stocks to invest in. We believe low realized volatility can potentially lead people to underestimate the risks inherent in these businesses including cyclical exposure, potential regulations regarding online activity or antitrust concerns or disruption risk as they encroach into each other’s businesses.
Mechanically, we expect that as the realized volatility of a stock drops, more passive “low vol” strategies buy the stock, pushing up the return and dampening downside volatility. The fear is that if fundamental events cause volatility to rise, these same passive vehicles will sell and exacerbate downside volatility.
Implicit in that is the very same “perpetual motion machine” dynamic that Marks warned about just over a month later. Recall the following from the above-mentioned “There They Go Again” letter:
The low fees and expenses that make passive investments attractive mean their organizers have to emphasize scale. To earn higher fees than index funds and achieve profitable scale, ETF sponsors have been turning to “smarter,” not-exactly-passive vehicles. Thus ETFs have been organized to meet (or create) demand for funds in specialized areas such as various stock categories (value or growth), stock characteristics (low volatility or high quality), types of companies, or geographies. There are passive ETFs for people who want growth, value, high quality, low volatility and momentum.
But what does “passive” mean when a vehicle’s focus is so narrowly defined? Each deviation from the broad indices introduces definitional issues and non-passive, discretionary decisions. Passive funds that emphasize stocks reflecting specific factors are called “smart-beta funds.
Importantly, organizers wanting their “smart” products to reach commercial scale are likely to rely heavily on the largest-capitalization, most-liquid stocks. For example, having Apple in your ETF allows it to get really big. Thus Apple is included today in ETFs emphasizing tech, growth, value, momentum, large-caps, high quality, low volatility, dividends, and leverage.
See what I mean? It’s the same criticism or actually, that’s not quite the right word. It’s not so much a “criticism” as it is an observation. It just is the case. And if you read all of that right, you understand that it is inherently self-feeding.
Now let me take this one step further by suggesting that factor-based investing, when it manifests itself in “smart-beta” products, is a perversion of the term “passive”. Allow me to quote myself here. The following is from one of my recent Dealbreaker columns:
How exactly is zeroing in on these factors a “passive” strategy? Past a certain point, you’re just picking stocks. That is, the more narrowly defined the factor, the more inherently non-passive it is.
And then what happens when market forces end up making certain stocks synonymous with multiple factors? Like, for instance, what happens when “momentum” becomes synonymous with “growth” or when an ongoing rally in stocks like the FAAMG constituents makes them synonymous with “low vol.”?
Well, I’ll tell you what happens. What happens is that you end up with factor crowding.
These funds have exploded in popularity, with AUM in smart-beta products tripling in five years to some $600 billion last year from under $200 billion in 2012.
All of this is inextricably bound up with the notion that ETFs and passive investing are gradually eroding price discovery.
That’s obviously a contentious debate, but should it be? Probably not. I like to focus on what I’ve variously characterized as the second-order effects.
In the post-crisis world, $15 trillion (give or take) in developed market central bank liquidity created a relentless hunt for yield that manifested itself in a mad scramble down the quality ladder into riskier and riskier assets. Investors eventually learned to simply frontrun dovish forward guidance at the first sign of trouble and by 2017, “buy-the-dip” had completed its metamorphosis from a derisive meme about retail investor gullibility to a virtually infallible investment “strategy” (those interested in that metamorphosis can read an in-depth take here). That dynamic drove benchmarks (and, by extension, the ETFs that passively track them) inexorably higher.
If you’re an active manager, it’s pretty hard to beat a benchmark that never falls, especially when you’re handicapped by the fees you’re charging. So, by the time Q3 2017 rolled around, it was readily apparent that some active managers had simply resigned themselves to their fate by going on what Wells Fargo described as a “seller’s strike.” Recall these fantastic excerpts from a note out last October which described passive investing as “QE for U.S. stocks”:
With QE, the Fed removed from circulation a material part of the Treasury market (by our calculations over 20% at the peak). The decreased Treasury ‘float’ as well as the reduction in the amount of natural sellers (with the reduced float) coincided with the general upward trend in Treasury prices or lower yields. Read: Scarcity value and Fed front running.
Currently, the shift to Passive is coinciding with ever higher equity prices with many equity indices trading at or close to all-time highs. As QE seemed to exaggerate trends in the fixed income markets, so it appears that Passive equity flows are exaggerating stock movements.
Recently we’ve observed consistent net inflows to Passive Equity funds, which have morphed into a type of Black Hole. Money goes in and stocks never come out (as least for now).
That’s obviously hilarious, and if you read the full note, it gets even funnier when Wells starts to describe the conversations they were having at the time with clients. Here’s one more quick excerpt:
Clients have said repeatedly that any time they’ve sold or tried to reposition in the last 3, 6, or 12 months, they’ve come to regret it. To fix this issue, they’ve decided to all together stop, or dramatically slow, their selling and it’s worked—relative performance continues to improve.
So now they’re passive investors too. What you end up with is a market that is almost entirely reliant on inertia.
About a month after that note was released, Goldman was out with what was, at the time, the latest version of their quarterly hedge fund monitor and guess what? Turnover for the three-month period was just 26%, a record low and turnover of the largest positions plunged to just 13%.
Fast forward to the latest update (i.e., current through the end of Q1 2018) and the picture hasn’t materially changed, although I should note that Info Tech turnover did jump by roughly 3pp during the quarter.
While Apple (AAPL), Alphabet (GOOGL), and Netflix (NFLX) were among the stocks with the largest declines in popularity among hedge funds in Q1 (and yes, some folks not named Warren Buffett were selling Apple), the overall picture is a familiar one:
Look at the annualized run rate on inflows into tech:
All of that brings us neatly to the latest from Howard Marks which grabbed headlines last week. His newest letter is called “Investing Without People” and it is sure to irritate those who aren’t fond of his take on ETFs and passive investing.
Frankly, Marks’s critique is devastating. Here he is exposing the inherent irony of the entire passive enterprise:
Is it a good idea to invest with absolutely no regard for company fundamentals, security prices or portfolio weightings? Certainly not. But passive investing dispenses with this concern by counting on active investors to perform those functions. In short, in the world view that gave rise to index and passive investing, active investors do the heavy lifting of security analysis and pricing, and passive investors freeload by holding portfolios determined entirely by the active investors’ decisions. There’s no such thing as a capitalization weighting to emulate in the absence of active investors’ efforts. The irony is that it’s active investors – so derided by the passive investing crowd – who set the prices that index investors pay for stocks and bonds, and thus who establish the market capitalizations that determine the index weightings of securities that index funds emulate. If active investors are so devoid of insight, does it really make sense for passive investors to follow their dictates?
Hmmm. Good question, no?
And Howard has lots of other good questions. He asks, for instance, whether the prevalence of passive investing will eventually mean enormous opportunities for whatever active managers are left. That’s another way of asking how far the shift needs to go before enormous distortions begin to show up. On that issue, he quips that in a world where no one bothers to assess what the fair value is for publicly traded companies, he’ll “gladly be the only investor working in the world.”
Marks moves on to ask the big question: “Does passive and index investing distort stock prices?”
His answer to that question comes in five parts, but I’ll just focus on three of them. He first notes that if what you want to do is effectively construct a strawman or otherwise adopt the most simplistic argument possible, then the answer to the distortion question is “no”. Here’s Marks:
The first level concerns the relative prices of the stocks in a capitalization-weighted index. People often ask whether inflows of capital into index funds cause the prices of the heaviest-weighted stocks in the index to rise relative to the rest. I think the answer is “no.” Suppose the market capitalizations of the stocks in a given index total $1 trillion. Suppose further that the capitalization of one popular stock in the index – perhaps one of the FAANGs – is $80 billion (8% of the total) and that of a smaller, less-adored one is $10 billion (1%). That means for every $100,000 in an index fund, $8,000 is in the former stock and $1,000 is in the latter. It further means that for every additional $100 that’s invested in the index, $8 will go into the former and $1 into the latter. Thus the buying in the two stocks occasioned by inflows shouldn’t alter their relative pricing, since it represents the same percentage of their respective capitalizations.
Ok, now go back up and read what I said just before I launched into the discussion about turnover. Just so we’re on the same page, here’s what I said above:
All of this is inextricably bound up with the notion that ETFs and passive investing are gradually eroding price discovery. That’s obviously a contentious debate, but should it be? Probably not. I like to focus on what I’ve variously characterized as the second-order effects.
Marks agrees. He goes on to explain the “second and third level” effects, one of which is the straightforward assessment of distortion in stocks that aren’t included in an index. To wit:
Clearly with passive investing on the rise, more capital will flow into index constituents than into other stocks, and capital may flow out of the stocks that aren’t in indices in order to flow into those that are. It seems obvious that this can cause the stocks in the indices to appreciate relative to non-index stocks for reasons other than fundamental ones.
Next, he explicitly addresses everything said above about “smart-beta” and factor-based strategies. Here’s Howard:
The third level concerns stocks in smart-beta funds. The more a stock is held in non-index passive vehicles receiving inflows (ceteris paribus, or everything else being equal), the more likely it is to appreciate relative to one that’s not. And stocks like Amazon that are held in a large number of smart-beta funds of a variety of types are likely to appreciate relative to stocks that are held in none or just a few. What all the above means is that for a stock to be added to index or smart-beta funds is an artificial form of increased popularity, and it’s relative popularity that determines the relative prices of stocks in the short run.
Good luck arguing with that.
Marks goes on to deliver a lengthly critique of quantitative investing and he ties that into the passive investing debate as follows:
It seems to me that while the members of both fraternities might reject the comparison, quantitative investing has some things in common with smart beta ETF investing. Both are rules-based, pursuing the attributes the managers want in their holdings. In both, once the rules are set, the humans (largely) take their hands off the wheel and leave implementation up to computers.
What might surprise you is that Marks’s conclusions in terms of what the future holds for active management are not at all emblematic of someone who is attempting to justify a dying profession in the face of sea change. In fact, one could easily come away from Howard’s latest with an even more dour outlook for active management than one harbored before reading the note. If you think you’re hard on active management, well then maybe click through to the full letter (it’s linked above), scroll down to the end of page 14, and read the five bullet points from Marks about “what these things imply for the future”.
Most of the media coverage that I’ve seen of Howard’s latest missive focuses on his comments regarding quantitative strategies. I plan to get around to doing a separate piece on that, but I wanted to do this one first because I think his ongoing critique of the passive revolution is more immediately relevant for everyday investors.
Again, there are parallels and in some respects, the two debates (i.e., the discussion of passive investing and the debate about systematic strategies) are inextricably bound up with one another for a variety of reasons, not the least of which is the fact that the momentum created by passive investing creates signals for some systematic strats. Indeed, to the extent passive investing helps to tamp down volatility, it could easily be argued that it’s indirectly forcing volatility-sensitive strategies to increase leverage and leading VaR models to run exposures that bump up against pre-defined risk limits.
But the overarching point of this post is to (again) prompt retail investors to consider the fact (because that’s what it is – a fact) that epochal shifts in market structure do not take place in a vacuum. There are unintended consequences when the dynamics that govern how trillions of dollars is allocated change.
More importantly still, the current market structure (composed as it is of mountains of money sitting in passive funds) has never been stress tested. Here’s Marks on that:
The vast growth of ETFs and their popularity has coincided with the market rally that began roughly nine years ago. Thus we haven’t had a meaningful chance to see how they function on the downside. Might the inclusion and overweighting in ETFs of market darlings – a source of demand that may have driven up their prices – be a source of stronger-than-average selling pressure on the darlings during a retreat? Might it push down their prices more and cause investors to turn increasingly against them and against the ETFs that hold them? We won’t know until it happens, but it’s not hard to imagine the popularity that fueled the growth of ETFs in good times working to their disadvantage in bad times.
Perhaps the best thing about Howard’s letter is that he kicks it off by saying that when it comes to the dynamics that are rapidly reducing the “role of people” in capital markets, he doesn’t claim to have any expertise:
Before diving in, I want to state loud and clear that I don’t claim to be an expert on these subjects.
Well, Howard, you may not “claim” to be an expert on them, but you most certainly are.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.