The Anti-Fundamentals Paradigm from Passive Investing

I listened to an interesting podcast with Mike Green this week about the implications of passive investing. This isn’t new, and I’ve heard some of this before, but he mentioned a number of implications I thought of and something clicked.

Here’s the podcast: Season 3, Episode 21: Dangers Lurk in Market Structure’s Changing Dynamics – The Contrarian Investor Podcast (contrarianpod.com)

Think for a bit about how money flows into and out of companies whenever money is switched from an actively managed fund to a passive fund. Here are some of the strange implications:

  1. Anti-Fundamentals flow: Active managers do research to figure which companies will surprise on earnings and outweigh these companies and sectors. Sometimes they have a small amount in short positions in companies they think will disappoint. As money moves to passive, they have to reverse all of these trades to re-allocate into the index. Money will reallocate away from their picks and towards what they didn’t pick.
  2. The big get much bigger: Active managers have strict caps to prevent them from focusing too much money into any one stock. Passive ETF’s have waivers for this, so that over 27% of the popular SPY index are focused into just 9 companies (2 of the tickers are Google). Whenever an active fund is exchanged for a passive one, expect these juggernauts to get a big inflow of money:

Note that a lot of those companies at the top do an enormous amount of share buybacks to feed this frenzy. Could the top ten holdings become 37% of SPY over the next year? You’d better believe it!

3. Meme stock champions can remain winners for much longer than you think. I picked Gamestop and AMC Movie Theaters below because most people are well aware of the story behind them with the short squeeze and the various memes. Both video games and movies have been moving toward streaming for years, so they were unloved on a fundamentals basis.

The biggest passive funds by far are run by Vanguard and Blackrock. As you can see below, these institutions hold 17.3% of all Gamestop shares and 14.6% of all AMC shares. When you switch money to a passive account, you are buying these.

In case you don’t know what a meme is, it is basically a cute picture aimed at getting people excited about crowding into a particular trade. Prime example of a meme:

Even the known fraud Nikola, with the CEO fighting in court and the tentative GM contract pulled, is STILL trading at a $4.25 Billion market cap – with Vanguard and Blackrock among the top holders!

4. Much less cash on the sidelines. It is very common for a mutual fund manager to hold 5% in unallocated cash. They do this to deal with various frictions such as account withdrawals, reallocations, and even minor trading so they can take some profits on a big gain or add a bit when the market drops. Passive funds don’t do any of that – they invest 100% by simply purchasing when money comes in, selling when money goes out, and holding in between. That means whenever you switch from an active fund to a passive fund, 5% of that money is newly added to the market which drives the index higher.

5. Much less market liquidity. During the week preceeding the pandemic announcement, the US stock market was collapsing lower day after day. In just 1 month, the S&P 500 dropped all the way from 3,385 to 2,237. The head of Vanguard announced with pride that less than 1% of his accounts traded during that time. What happened?

5A. Leading up to March 2020, there were plenty of warnings about Covid-19 from the harsh reactions in China to the cases found in New York and Italy. Active managers were watching with nervous anticipation, but the market kept climbing into mid February.

5B. Some of the big political insiders got wind that lockdowns were coming and dumped their holdings, followed by other active managers as they got skittish. This only accelerated when the news actually got out.

5C. For every seller, there must be a buyer. Passive funds pay no attention to pricing whatsoever – they don’t see a bargain when stocks are cheaper or a ripoff when they get too high, they just mechanically buy when payrolls send more 401k money in. There were very few entities able and willing to buy during this market drop, many of whom were hedge fund managers closing out their short positions.

5D. March 23rd, 2020 marked the bottom, as the federal reserve came in with a big announcement. Interest rates plunged lower in reaction. Active managers stopped selling. Some started buying. Early April saw an enormous buying binge as target date funds with fixed stock/bond ratios all had to re-balance their holdings in a period that had seen stocks plummet and bonds jump higher in value.

5E. From April 2020 on through today, the market marched relentlessly higher as payrolls kept putting money into 401k funds and many corporate buybacks continued forward. The buying frenzy picked up as active managers realized they were being left behind and started piling in. Low interest rates and the idea of Federal Reserve support created an environment of increasing leverage, as more and more funds started to use margin lending and other forms of borrowing to pile even more money into the markets. Anyone who was bearish lost big time and had to change tactics or quit trading. Narratives came and went in a frenzy as everyone tried to somehow tie the market reaction with recent news or fundamentals in some way – but fundamentals really had nothing to do with this rise.

6. Dismal performance from active managers leads to more switching. Active managers have had their fundamental analysis/earnings driven world turned upside down. Anything they hold gets sold off and anything they avoid or short gets bought up. If their account holders don’t switch their funding, they are heavily incentivized to become closet indexers themselves. Maybe they’ll shoot it to a few different passive funds (which all hold greatly overlapping stocks), so they can meet the index. Keep in mind that showing a 6% gain when the S&P 500 is up 10% can get them fired, but a 10% loss when the S&P 500 goes down 10% is expected.

What Now?

I honestly think this keeps going. We may see some big selloffs from exogenous events, but they’ll turn around just as quickly as long as the passive cash flows keep moving. I’m well aware that this can’t last forever, but try to think about what can stop it?

  1. An exogenous event like Covid-19 lockdowns could get a lot of active managers to sell, maybe even get some people to switch their 401k’s to money market funds. This would create a sharp selloff, followed by a reaction from the federal reserve, followed by the same pattern we saw after March 2020.
  2. A liquidity event could strike. The collapse of Archegos didn’t cause it, but there is speculation that Evergrande might. This would involve big hedge funds de-risking their portfolios by selling and reducing margin debt and other leverage, which would result in a bigger drop than #1 above. The federal reserve and federal government would react to “stabilize” things, but unless it was big enough to engender distrust of passive investing the same result would ensue.
  3. Retirement funds could start getting redemptions. This is many years off, however. Most actively managed funds are held by the older generation, who are slowly switching due to the increasing amounts of closet indexing by their managers. As they retire, they aren’t going to switch money into bonds all of a sudden, more likely they’ll leave the money with the same managers. Even if they have “forced distributions,” that doesn’t mean they’ll spend the money – it just means they’ll pay some taxes and move some money to after-tax investment accounts. No real selling in bulk will happen here until the median boomers are actually passing away and the accounts are divided among their heirs.
  4. Passive funds could hit a critical threshold where they are so big that the market stops functioning effectively. Whenever someone wants to buy or sell shares, someone has to be there to make the market. What happens when so much of it is held by passive funds that there is simply no more MSFT or AAPL for them to buy? Again, it seems like this outcome is years down the road.
  5. Political change. You can’t rule out the rules of the game being changed, especially with the wealth disparity and political anger as high as it is today. This is a roll of the dice however, and it could just as easily accelerate the process (like the Covid-19 reaction) as disrupt it.

What about inflation?

Inflation is widely misunderstood. The crux of the matter today is really all about QE. You either believe that quantitative easing is money printing and that we have excess dollars all over the place, or you believe that QE is a largely irrelevant asset-swap and the federal reserve is actually mainly using the policy they call “forward guidance” to encourage people to invest and spend.

I’m a big fan of Jeff Snider’s writing, and I’d encourage you to read some of it if you’re curious about the workings of the monetary system. Right now I’ll stick with one key chart I’m pulling from here: Leading Out From Japan – Alhambra Investments (alhambrapartners.com)

Japan pioneered the idea of using their central bank to buy up bonds in what they called “Quantitative Easing” back in 1998, and it still resulted in a deflationary environment with dropping interest rates despite all the ramp-ups which have even gone to purchase much of the Japanese stock market and even some of the US stock market. This should have created enormous inflation, but didn’t.

The crux of the matter is HOW the central banks are making these purchases. Essentially, they are buying these holdings directly from big banks that have accounts with the central bank, and they are crediting these banks with “overnight reserve assets.” These reserve assets are NOT money, and they cannot be cashed in for executive bonuses, stock buybacks, debt reduction, or anything else.

What can these banks actually do with overnight reserve assets?

  1. They list them on their balance sheets as assets. For accounting purposes, it counts towards a positive book value.
  2. They can settle liabilities with other big banks that hold an account with the central bank. If your employer pays you from their wells fargo account to your citibank account, then wells fargo can transfer “overnight reserves” over to citibank in order to settle this transfer.
  3. They earn interest on this overnight reserve based on whatever the central bank decides. In Europe or Japan they may charge for holding these as part of negative interest rate policy, but in the US they usually get paid some miniscule token amount for holding them, currently an 0.25% annual rate.

Anyway, I’m in the deflation camp in that I believe the inflation we’re seeing is not from an excess of US dollars. The supply constraints from Covid has been significant, as have the temporary government assistance and one-time check payments to Americans. Meanwhile, the fed’s cherished “wealth effect” has worked like a charm as money has plowed into investment vehicles driving up the costs of a variety of investment assets including housing.

Steven Van Metre, a deflationist with on his YouTube channel, asked the following question: With a record number of 60 enormous cargo ships waiting outside the port of Long Beach, CA just as government benefits are drying up and congress fights over the debt ceiling with lower and lower stimulus targets, how much money will consumers have left to purchase all of that inventory when it hits the shelves?

Consider that we’re still 5 million workers shy of January 2020, and anyone who has been skipping rent payments during the moratorium is about to get evicted. Also consider that the vast majority of the wealth gain has gone to the top 1%, who may be able to fly to space on vacation, but they won’t be purchasing boatloads of consumer goods.

Next, consider the situation with Evergrande and the clampdown that China has been having on their big companies. This is a serious problem if you’re long commodities, as the Chinese government is clearly not interested in building enormous “ghost cities” like they did in 2008 as they encouraged a property-purchasing frenzy. Even though I expect the financial spillover to be somewhat limited, I am seriously starting to wonder how much of a dent this will have in the use of base metals and anything involved in construction over there.

I have to admit, I’m also nervous about a pullback in precious metals, as I hold the bulk of my money in a variety of precious metals miners. I’m not planning on selling; Gold and Silver spent a decade carving out a base in pricing during which miners cut back heavily on exploration and development and they aren’t primary metals used in construction. I still believe this decade will be great for these metals even if there is turbulence ahead. Plus, I like something that isn’t tied to the passive investing ponzi we see developing.

Anyway, one thing I’ve done is I’ve decided to get some bullish market bets on the table. One of the guys I’ve been following on twitter for a while just launched a technical analysis/charting service where he finds stocks with bullish chart formations and posts target prices, using a combination of traditional technical analysis with his own take of Elliot Wave formations. His twitter handle is @DereckCoatney with proprietary handle @Derecks_Trades

My current holdings:

  • HEDGES (20.2%)
    • 19.0% TLT Calls
    • 1.2% EEM Puts
  • PRECIOUS METALS (47.1%)
    • 9.3% AG (Silver), mainly shares & some calls
    • 6.0% SAND (Gold, Silver & others), all calls
    • 5.4% EQX (Gold), mainly calls & some shares
    • 4.7% LGDTF (Gold)
    • 4.2% SILV (Silver)
    • 3.9% SILVRF (Silver)
    • 3.5% MTA (Gold & Silver)
    • 3.0% MGMLF (Gold)
    • 2.1% RSNVF (Silver)
    • 1.7% SSVFF (Silver)
    • 1.6% LWDEF (Gold)
    • 1.2% WPM (Gold, Copper & Silver), all calls
    • 0.7% GOLD (Gold, Copper), all calls
  • URANIUM (13.3%)
    • 7.1% CCJ, covered calls sold on all of it
    • 4.8% UUUU, covered calls sold on all of it
    • 1.4% BQSSF
  • COPPER & NICKEL (5.4%)
    • 5.4% NOVRF
  • CANNABIS (8.8%)
    • 1.6% CRLBF
    • 1.6% GTBIF
    • 1.7% TRSSF
    • 1.2% CCHWF
    • 1.4% AYRWF
    • 1.3% TCNNF
  • DERECKS TRADES (1.5%)
  • CASH (3.8%)

I did actually buy some RSNVF and SSVFF last week as these silver miners were hammered and I didn’t have much of a stake in them anyway. I am very skeptical about adding more to this sector at the moment though – I’m not selling, but I want to be able to add if we see a significant price drop. In my opinion, the fundamentals are sound and they’ll be fine, but we may see something like the precious metals selloff we saw in 2008-2009 before continuing to their 2011 peaks.

I also bought a decent amount of Cannabis stocks as those were hit pretty hard as well, and I’m thinking they’ve come down enough to potentially stabilize. I’ll continue adding on big drops only with a target of around 10-12% of my portfolio going there.

The Derecks Trades section is simply call options at a variety of strike dates, mainly December, currently divided between 9 different stocks that had bullish chart formations which will go up significantly if they hit their targets. While call options can easily go to zero in a sideways market, I am not expecting a sideways market – we will either have a March 2020 style drop or continue ratcheting higher. Plus, this allows me to put money into companies that have lousy fundamentals so I can reap some of the gains from the passive investing trend without being worried about losing big.

Good luck getting your head around this new paradigm – the implications still have my head spinning. Like I should buy Tesla with a 400 P/E ratio because it’s expensive, it’s in the S&P 500, and active managers hate it … I’m getting dizzy just thinking about it.

About johnonstocks

I've been trading stocks since 2003, active on Motley Fool's discussion boards and using first Hidden Gems, then Global Gains. I no longer have the newsletters, but I keep up on the WSJ and read David Rosenberg everyday at gluskinsheff.com. Education: CFA level 2 candidate MBA-focus in Finance, Marshall, University of Southern California - expected Dec 2010. BS Mechanical Engineering, UC San Diego, June 2002
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