Over the past decade, one of the most undeniable invest- menttrendshasbeenthemove
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
For perspective on how this dynam-
ic 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, exces-
sive flows into the largest stocks have
pushed up their valuations while small-
er 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.
BUILDUP DANGERS WHEN STOCKS
The market distortions stemming from
the recent passive push have set equities
up for a new set of risks and disloca-
tions when these trends unwind. The
longest bull market in history can’t go on
forever. When a volatility event strikes
and money flows out of equities, much
of it will come from all the flows that
recently poured into passive products.
As that happens, factor trends will
reverse themselves. For example, money
flowing out of index-based products will
likely adversely affect the largest stocks
in the index. The size factor will outperform as smaller stocks do better.
Active managers in traditional asset
classes such as equity have said they
can take advantage of passive outflows
in down markets, snatching up favored
stocks as they trade lower. But alternative strategies, and specifically long/
short equity strategies, may be best positioned to capitalize on the distortions
passive flows have created.
Long/short funds are best known for
taking both long and short positions in
stocks. Historically, this has helped such
strategies perform relatively well when
markets sell off because the gains from
the short positions offset losses in the
Lesser known is the fact that many
long/short funds decide what stocks to
go long or short based on what factors they believe are likely to out- or
under-perform. Some of these funds
even dynamically adjust what factors
to short or go long based on the market
Advisors will need to conduct due diligence on how a manager dynamically
adjusts their factor positioning — and it
goes without saying that the long/short
manager needs to be correct on their
factor calls — but long/short funds could
find themselves in a unique position to
benefit when the disorienting factor
trends from passive investing reverse.
Josh Vail, CAIA, is president, 361 Capital.
By Josh Vail
How to Handle Risk That Passive Growth Poses
Indexing, especially in large cap equity, has reached a critical mass that
could distort markets. Long/short funds might be an advisor’s insurance.