Passive Investing's Dangerous Side

Last week, we discussed the inelastic market hypothesis academic paper presented by Ralph Quajin and the interesting dynamic it portrays where a $1 investment in the market can potentially move valuations up by $5. This can be an exhilarating game during market upswings, but unfortunately, it operates in reverse as well.

It is crucial to note that since the inception of passive investing, nearly every day has seen positive passive flows. This continuous growth in passive investment funds, whether from Vanguard, BlackRock-managed funds in 401Ks, or individual ETFs purchased by investors, has led them to become significant net buyers of stocks in the market. Passive funds, unlike actively managed funds, are structured differently, as they are required to own everything in an index they track. For example, an S&P 500 index fund holds all the stocks in the index without any cash reserves, which is common for actively managed funds.

The unique structure of passive funds impacts their behavior in the market. Active managers typically hold a percentage of cash in their portfolios for various reasons, such as handling redemptions, seizing tactical opportunities, and facilitating fee payments. Conversely, passive funds lack this flexibility. When they experience inflows, they must purchase stocks accordingly; if there are outflows, they must sell immediately, regardless of market conditions.

The inelastic market hypothesis by Ralph Quajin illustrates the potential risks associated with this structure. During periods of net inflows, stocks can be aggressively bid up, attracting short-term traders. Conversely, when outflows occur, passive managers are compelled to sell quickly, potentially exacerbating market downturns.

Several factors could escalate this situation, including demographic shifts towards a smaller working population supporting retirees, automatic asset reallocations in target-date funds as investors age, and market disruptions like the bond market turmoil witnessed in 2022.

While predicting the exact trigger to reverse passive flows is challenging, the risks posed by the current market dynamics are significant. Investors should be cautious, especially given the high valuations of certain stocks. The market may currently deem them as appropriately priced, but in a sell off do not look for value investors to rush into purchase shares at anywhere resembling current prices.

Be safe out there.  I have a more uplifting topic for next week. There is one sector in the market that offers almost all of technology gains with much less risk and volatility. What could it be?