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The Matthew Effect, passive investment strategies, and ships and shipwrecks

For years, passive strategies have been capturing business from active managers because they are cheap to run and outperform. 

Family offices often use indexed funds to save fees and invest in alternatives. Half of US equity funds are passively managed. The global value of ETFs has soared to $10 trillion. 

It’s been a wonderful run. But it could come at a cost to judge by data which suggests we are likely to experience more market shocks, as a result of the way trading has switched from stocks to indices. 

As French philosopher Paul Virilio once said: “When you invent the ship, you also invent the shipwreck.” 

Right now, there is no sign of indexation running out of steam. On the contrary, momentum has been building, due to a boost from the Matthew Effect, defined by sociologist Robert Merton, where success breeds success, at the expense of those less fortunate. 

The term derives from St Matthew’s tale of the parable of the talents, where two servants doubled money on trades carried out for their master and earned promotion, unlike an anxious colleague who buried his money in the ground and lost his job.

When you invent the ship, you also invent the shipwreck

Active managers don’t exactly bury their clients’ money. But family offices are certainly sick of paying fees to them, only to see their money trapped in poorly-performing funds.

According to index provider Standard & Poor’s, 94% of active funds have failed to beat their benchmark over twenty years. High fees were a factor behind the failure of active managers, along with a habit of selling stocks at the wrong time.

Active managers have lately looked even more foolish after failing to take account of the way money has been flooding into passive funds when investing. Large-cap growth stocks have particularly benefited from passive inflows, due to their high index weightings.

For sure this reflects their growth prospects. But the support provided by passive flows provides more constant support to large cap growth than active managers, who tend to take profits on the way up.

Tesla’s shares doubled after news it would join the S&P 500 index in December 2020.  True to their style, active managers were quick to take profits on the stock, during its price rise, only to miss out on subsequent gains. Despite this year’s set back, Tesla’s market value is double its market value towards the end of 2020. It currently exceeds $1 trillion, on 340 times earnings.

We also saw passive flows working their magic when money moved into green ETFs last year, pushing small fuel cell stocks to the sky. Elsewhere, value stocks weakened considerably, due to an absence of support, providing private equity with takeover opportunities.  Shareholder activists have also become more prominent, because investors have become irritated at the low ratings of traditional companies, although they have improved slightly this year. 

Edmund Bellord, a portfolio manager with Harding Loevner, has sensed a serious threat from indexation. In a recent research note, he pointed to the way traders have become more involved with ETFs and index futures. They are constantly making bets on macro data, pushing the indices one way then another and leaving stocks to play catch-up.

This is quite a contrast to previous years where markets would maintain their momentum from one day to another, as active managers steadily bought into an argument to buy or sell stocks. The technical term for this is serial dependence. These days, it implies that a range of indices tend to move the same way in response to new data, amplifying the response in times of trial. 

Forecasts of the future volatility of the index options have also become more fraught. Volatility is measured by The Vix index, known as a “fear gauge” because it measured market disorder. The Vix has been quiet since 2008, putting aside the sharp price spike of 2020, when news of the pandemic first broke.

But to measure potential disorder, you need to track the volatility of the VIX. And it is here that the going has got more choppy.

According to Bellord: “Since 2006, a period coinciding with the boom in passive investing, volatility of volatility has shown a consistent upward trend. The range of potential disorder is expanding.”

He concludes: “It used to be that uncertainty about the future flowed from individual stock prices into indices.  Now, the tide has been reversed and uncertainty propagates from indices to individual stocks.”

All this may – or may not – lead to a great unwinding, predicted by investors like Jeremy Grantham and Ray Dalio, with rises in inflation and interest rates, plus conflict in Ukraine, acting as triggers. If any future disorder becomes too great, and passive investors react by pulling money out of the market, it is also unlikely there will be many active managers prepared to take the other side of the Tesla trade, on the way down. 

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