JP Morgan: Why Future Market Crash May Be Worse

Posted by Patrick Ceresna on Oct 30, 2016 1:28:00 PM

JP Morgan's Nikolaos Panagirtzoglou:
Markets become more brittle, risky: "The shift towards passive funds has the potential to concentrate investments to a few large products. This concentration potentially increases systemic risk making markets more susceptible to the flows of a few large passive products."
Crashes, when they happen, will be bigger and badder: "the shift towards passive funds tends to intensify following periods of strong market performance as active managers underperform in such periods of strong market performance. In turn, this shift exacerbates the market uptrend creating more protracted periods of low volatility and momentum. When markets eventually reverse, the correction becomes deeper and volatility rises as money flows away from passive funds back towards active managers who tend to outperform in periods of weak market performance."
Markets become less efficient: "if passive investing becomes too big, potentially crowding out skilled active managers also, market efficiency would start declining. In turn, this would present opportunities for active managers to extract arbitrage profits."

All content presented are excerpts of a zerohedge post that can be found using this link

The rise of passive funds at the expense of active funds has been well documented and has attracted widespread attention in the press recently. Figure 1 shows that the shift towards passive funds has been a trend that started before the Lehman crisis but intensified after the Lehman crisis. In fact after the Lehman crisis the trend towards passive investing has been boosted by the explosive growth of ETFs, the AUM of which currently stands at $1.8tr, from $0.5tr before the Lehman crisis, i.e. the ETF universe more than tripled since the Lehman crisis. For comparison, the AUM of mutual funds worldwide grew 53% over the same period.

Figure 3 and Figure 4 also show that the shift from active to passive investing appears a lot more advanced in the equity fund vs bond fund space. For example, active equity mutual funds started experiencing outright outflows after the Lehman crisis in the US and these outflows intensified after 2014. Active bond mutual funds started experiencing outright outflows more recently after the taper tantrum of 2013

jpm flows 2.jpg

1) End investors such as retail investors are becoming more important in driving markets. Swings in retail investor sentiment, which are often abrupt due to typically shorter investment horizons than institutional investors, are transmitted into markets more quickly as the cushion from active managers accommodating retail investor flows is removed. For example, if retail investors turn suddenly bearish and decide to withdraw a lot of previously invested active funds from the market, active managers could accommodate this selling pressure by running down their cash balances. In this way, the bearishness of retail investors is transmitted less abruptly to markets relative to the case where retail investors withdraw their money from passive funds that hold no cash balances. In other words, active managers inject a degree of convexity to markets which would naturally diminish if passive investing becomes even more dominant in the future.

2) Markets could see more protracted momentum periods coupled with deeper corrections. Markets would see more protracted uptrends to the extent that there is more herding in retail investors’ behavior. In addition, the shift towards passive funds tends to intensify following periods of strong market performance as active managers underperform in such periods of strong market performance. In turn, this shift exacerbates the market uptrend creating more protracted periods of low volatility and momentum. When markets eventually reverse, the correction becomes deeper and volatility rises as money flows away from passive funds back towards active managers who tend to outperform in periods of weak market performance.

3) The shift towards passive funds has the potential to concentrate investments to a few large products. In turn, asset concentration potentially increases systemic risk making markets more susceptible to the flows of a few large passive products.

4) Passive or index investing favours large caps as most equity indices are market cap weighted. This could exacerbate the flow into large companies beyond to what is justified by fundamentals, creating potential misallocation of capital away from smaller companies. To the extent that these passive funds become even more dominant in the future, the risk of bubbles being formed in large companies, at the same time crowding out investments from smaller firms, would significantly increase.

5) The proliferation of index funds increases the size of stock inclusion flows. In turn, market moves around index constituent changes become more pronounced overpenalizing companies leaving the index and causing excessive gains to companies entering the index.

6) Passive investing potentially reduces corporate activism. The conventional wisdom is that passive owners will show little interest to corporate governance relative to active managers and as a result corporate activism would naturally decline. But there is little empirically evidence of that happening. Gormley , Keim and Appel showed in their academic work show that mutual fund firms which focus on passive investing do indeed cast their shareholder votes to press for change, and do it effectively. In addition, they show how passive investing also leads to more aggressive shareholder activism than there would be otherwise, as passive fund firms add their clout to campaigns waged by activist investors.

7) Passive investing potentially reduces market efficiency. This is again the conventional wisdom but we believe that this argument is not entirely correct and could be valid only after the shift away from active towards passive funds becomes more advanced. Initially the opposite could be argued. It could be argued that the shift away from low skilled active managers to passive investing could increase market efficiency as the noise from low skilled managers is reduced. But if passive investing becomes too big, potentially crowding out skilled active managers also, market efficiency would start declining. In turn, this would present opportunities for active managers to extract arbitrage profits. In other words, if passive investing becomes too big, the portion of active managers outperforming the market would naturally rise and the flow would start shifting again away from passive towards active funds. So there is a natural limit of how high passive investing can grow at the expense of active managers. How high this natural limit is not yet clear. At the moment, there is little evidence of active managers generating enough alpha even as the share of passive funds has grown steadily nearly 30% in the US. In addition, the HF industry has been failing to generate alpha in recent years with little evidence of succeeding to do this so far this year as shown in Figure 5.

 Ceresna Comment: The market conditions are evolving and the precipitating factors that create the next bear market are never fully transparent in advance.  One thing that I do believe is that the growing trend of indexing, passive investing and/or systematic strategies will likely play a critical roll during the next down cycle.  Again this builds a case for learning to use options in your investment portfolio to hedge outlier risks.   

 

Topics: Market Crash, indexing

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