Over the past decade, one of the most undeniable investment trends has been the move toward passive products. The lower fees associated with index funds and a pretty good track record against active strategies in the most efficient markets has led many advisors to build their clients’ portfolios with passive strategies. But passive products’ success could be financial markets’ next undoing.
Passive products now comprise more than 50% of all U.S. large-cap equity investable assets, a critical mass that has created distortions within equity markets. Long/short equity funds may be uniquely positioned to capitalize when those distortions reverse.
Before looking at how advisers should position themselves against the risks from the passive product proliferation, however, it’s important to understand how disoriented markets have become.
As more money has flowed into passive products, it has disproportionately benefited certain factors, while pushing others extremely out of favor. A good example is the underperformance of the size factor. (When the size factor outperforms, it means smaller-cap stocks outperform larger ones).
When assets pour into ETFs or passive funds replicating an index such as the S&P 500, more money is allocated toward the largest names in the index. This has helped performance of mega-cap stocks and moved the size factor out of favor.
For perspective on how this dynamic has played out, the valuation gap between the quintile (based on price/sales ratios) of the largest stocks in the Russell 1000 and the quintile of the smallest stocks is at its widest since the unwinding of the internet bubble in 2000 and 2001. In other words, excessive flows into the largest stocks have pushed up their valuations while smaller stocks were left behind.
Factor distortions aren’t limited to size. The passive push has also led to extreme underperformance of the value factor, which by some measures is trading at its biggest discount since at least 2001, according to J.P. Morgan’s The Value Conundrum from June 6, 2019.
In short, an influx of capital into passive strategies has driven stock correlations higher. As stocks trade less on company specific fundamentals, it has created less potential for value stock price reversion when a company’s fundamentals improve.