It's not what you Invested in, it's the way you did it

Malt Liquidity 92

“Passive” Aggressive

A general rule of thumb I use when assessing economic theories is to proceed with caution if the proposing economist has never tested market reality. (I mean, I write a newsletter which averages multiple uses of “liquidity” per post, do you really think I’d let assuming it slide?)

Similarly, in terms of investing, I treat anyone who pounds the table and suggests that “everyone should passively invest” as Gladwellizing (read: over-generalizing) at best and clueless at worst:

And the winners are always few. In a 2018 paper in the Journal of Financial Economics, for example, Professor Hendrik Bessembinder analysed the returns of all companies listed on the NYSE, Amex and Nasdaq exchanges from 1926 to 2016. Total net wealth created was due to just 4 per cent of the 26,000 stocks. That is why I recommend only investing in passive funds. Then it doesn’t matter if everyone switches from Google to Bing to Baidu — or if they don’t. Yes, my portfolio will own loads of dud companies along the way. But the handful that smash it out of the park should more than compensate for the swing-and-missers.

First of all, there’s this misconception that passive funds are truly passive — take the S&P 500, for example, the most allocated-to “passive investment” and benchmark:

Based on data from a recent exhaustive study of index mutual funds,16 about 60% of the S&P 500 tracking funds use the term “passive” in the prospectus. This figure reflects the fact that 41 of the 69 index mutual funds that track the S&P 500 in the universe of mutual funds collected for that study use the term “passive” either in describing their investment strategy or as a risk factor of the fund…

…A second common use of the S&P 500 is as a benchmark. Globally, a mind boggling $15.6 trillion was indexed or bench-marked to S&P 500 as of December 2021.

While colloquially we think of the S&P 500 as the “largest 500 stocks”, this isn’t exactly the case — otherwise you would see a constant updating of the holdings based on size. Instead, there are criteria that a committee uses to deem which stocks are in the index:

• The company should be from the U.S.

• Its market cap must be at least $8.2 billion.

• Its shares must be highly liquid.

• At least 50% of its outstanding shares must be available for public trading.

• It must report positive earnings in the most recent quarter.

• The sum of its earnings in the previous four quarters must be positive.

This is not exactly unbiased, as these criteria certainly contain some level of discretion. I would hardly consider “highly liquid” an objective measure. Indeed, shares of AMC or GME are probably much more liquid than a fair chunk of S&P 500 stocks. Which, of course, leads us to the profitability filtering, which rids us of this conundrum — in effect, the S&P 500 is essentially biased towards the best-performing companies. No wonder so many actively managed funds fail to beat this! They’re benchmarked against constantly moving goalposts, as the paper notes:

While it is certainly true that in most cases the mutual fund manager cannot directly influence the performance of the Index, this fact alone does not make such
a comparison useful. Rather, for such a comparison to be useful to an investor, it must be the case that the Index provides an objective way to measure the risk-adjusted performance of this particular mutual fund. It is immediately obvious from the fact that the Index is just one particular large-cap portfolio that there is no
reason to believe that it is the right, or even an appropriate, benchmark for any particular fund. Some funds may happen to have a similar risk profile, but most won’t. On top of this, the fact that the constituents of the Index change substantially over time means that the investor can’t even use it as a reliable measure of the average performance of a particular fixed set of securities.

While hedge funds somewhat resemble highly-levered operations making GDP-sized bets on the particular shade of copper due to be delivered in 3 months more than, y’know, “hedging”, the point remains that the investment goals simply aren’t the same. Of course, one could (and should!) argue that for an individual, large cap exposure with dampened volatility relative to single stock exposure is good. But arguing this by hemming and hawing about active management “underperforming”, even by risk-adjusted metrics, isn’t really logically consistent. Think about how much SPY drew down in 2022, let alone March 2020 — should everyone be eating this kind of volatility? “Passive” investment is not in a vacuum — volatility drag does impact forward returns even if you “set and forget.” This is the intuition behind the stock/bond split, but then if both of them suffer drawdowns like they have recently, you’re still SOL! Diversified exposure exists for a reason.

This isn’t exactly supposed to be a defense of active investing, but rather I wanted to highlight the externalities of a “passive” market that is growing larger and larger, as I talked about in the last post:

A simple thought experiment — what happens if the market is entirely “passively invested”… and liquidity is demanded in the underlying? Liquidity is not created out of thin air — if you want it, you must pay for it. As long as there is both sufficient liquidity and a properly risk-adjusted reward, someone will tighten the spreads and bring the products in line. If the risk is too great, however, the quotes will never come in due to risk of ruin — in the scenario presented above, everything would go to zero.

I don’t think this becomes an issue until a much larger percentage of the market becomes passive, but certainly this is a little troubling:

But as long as money keeps sloshing into index funds — which it has been — they have to buy according to Tesla’s (diminishing) weighting in benchmarks. This means that Vanguard funds are now Tesla’s second-biggest shareholder, with a 6.85 per cent stake. BlackRock funds own 3.6 per cent and State Street Global Advisors controls another 3.13 per cent. That adds up to 13.58 per cent.

Some caveats. BlackRock, Vanguard and State Street all also have active funds, which can invest and probably in some cases are invested in Tesla. So their combined 13.58 per cent probably isn’t all owned by passives. But the vast majority will be. And anyway, if you include Fidelity’s passive business Geode Capital Management (now comfortably a top-10 shareholder with a 1.55 per cent stake) and Invesco’s QQQ ETF (another 1 per cent) then the passive ownership leaps to 16.13 per cent…

The best, most credible overall figure for “official” index fund ownership is the Investment Company Institute’s estimate of about 16 per cent of the US equity market as a whole. But the reality is that there are many de facto index-tracking investors that just don’t use index funds, and are therefore not captured by fund-based data. Reverse-engineering data from trading spikes triggered by index reshuffles, two academics last year estimated that at least 37.8 per cent of the US stock market is held by passive, benchmark-hugging investors.

I don’t argue that ETFs “buoy” bad stocks — although they do induce correlated trading across the basket — but given TSLA’s outsized options volume relative to the rest of the market, with more and more liquidity in the underlying being captured by passive inflows and outflows, one really wonders if this is amplifying both trends and volatility. While rudimentary stock-based delta-hedging has long been improved upon, even with an options-hedged-with-options model, illiquidity in the underlying affects how your inventory is managed. Most notably, I think this would affect the frequency of implementation of gamma-scalping strategies, which would contribute to the ludicrous trends and rippers that any trader of TSLA sees. While most of the media attention is focused on zero-days, I find the vol surface of the SPX complex to be ludicrously efficient given the flood of liquidity in every related product, and instead look to TSLA as sort of an example of how a market bifurcated entirely between passive and option flow would look, especially given the tendency of TSLA option traders to trade near-expiry options inside the exponential theta decay realm.

As I pointed out in the previous post, volatility and spread-tightness are inversely correlated. Of course, market makers make more when there is more volatility and trading volume. At the same time, if we are all looking to the bid-ask widening as an indicator of a move and crossing to get into long vol positions, the trade gets more and more crowded, which leads to very rapid movements into expiry and potentially (and probabilistically) highly uneven flow. While this isn’t systemic by any means — by nature, this will only happen on a few stocks — the fact that passive investors are obligated to hold such stocks will add to the volatility drag on their returns. It’s certainly something to keep an eye on going forward.