Losing the Wisdom of the Crowd: A Record Low VIX and the Rise of Passive Investing Could Fan the Flames of the Next Recession

The market’s so-called ‘investor fear gauge’ (the CBOE Volatility Index; better known as “the VIX”) set a new floor this summer, falling momentarily below 9 to its lowest ever level in intraday trading. While the markets have been calm this year, with over half of the 25 lowest readings ever in the VIX having occurred since May, the extreme lack of volatility has reignited investor suspicions that markets may have become too complacent and that a resurgence in volatility could be on the horizon. As investors fret over the lack of fear, we thought it was worth investigating the correlation between declining VIX readings and the rise of index investing – as well as the growing popularity of passive and quantitative investment strategies – which many believe could exacerbate the next recession.

The Rise of the Quants & the Indexers

According to Marko Kolanovic from JP Morgan, fewer investors are buying and selling based on stock specific fundamentals (he estimates that just 10% of trading volumes originate this way today), instead choosing to buy an entire index or invest in a fund run solely by algorithms, thus pushing volatility levels even lower. A recent column in the Wall Street Journal, appropriately titled “How Quants Calm the Stock Market” (linked below), noted that the share of trading done by funds run by algorithms has doubled in just four years to over a quarter of US stock turnover, while better information has led to fewer surprises as “information goes from completely unknown to completely known” in a matter of seconds. The growing popularity of index investing has accentuated the shift, with passive and quantitative trading strategies now accounting for 60% of equity assets, up from less than 30% a decade ago, causing crowds of cap-weighted indexers to load up on the same stocks and further suppressing market volatility.

The Promise and Peril of Index Investing

Last year, 4 out of the 5 most heavily traded securities were exchange-traded funds (ETFs), as the concept of indexation and the creation of new ETF products has accelerated the shift from active to passive investing. Frustrated investors have been pulling their money out of underperforming active funds to invest in low-cost broad market indexes, passive vehicles which guarantee that they will not underperform the index. That said, several hedge fund managers have been raising red flags, noting that by purchasing passive vehicles investors also surrender the possibility of outperforming the market, and, as articulated in a Barron’s column earlier this month (see “Man vs. Machine” linked below), “with cap-weighted indexes, index buyers have no discretion but to load up on stocks that are already overweight (and often pricey) and neglect those already underweight. That’s the opposite of buy low, sell high”.

The Bear Market Liquidity Test

While passive investing has outperformed actively managed funds in the recent bull market, ETFs’ promise of liquidity has yet to be tested in a major bear market, and indexing may drive volatility levels higher during the next recession. Howard Marks notes in his latest letter to investors that “it’s not clear where index funds and ETFs will find buyers for their over-weighted, highly appreciated holdings if they have to sell in a crunch”. He believes that the appreciation that has been driven by bulk passive buying will prove to be rotational, not perpetual, as “the same risk management that causes active managers to underperform in a bull market can lessen the pain of a correction, but passive investors have no option to hoard cash or diversify”. Several studies support this thesis, as Stack found that the Vanguard Total Stock Market Index fund (VTSMX) took 43 months to recover its losses after the 2000 bear market, while InvesTech’s model portfolio, which did not perform as well during the bull market, took just 11 months to bounce back.

The Paradox of the Popularity of Passive Investing

While indexing may be an appropriate strategy assuming the market is efficient, a problem arises if these vehicles become the market as they do not contribute to price discovery. Passive funds engage in a “basket-based mechanistic investing” strategy, buying stocks in the same proportion as the indexes they track and indiscriminately moving trillions of dollars without regard for individual stock prices or fundamental analysis. Thus, ETFs and passive funds do not have fundamental analysts who question valuations, and instead rely on the theory of efficient market pricing – entrusting the “wisdom of the crowd” of active buyers and sellers of individual securities to determine the equilibrium price. Yet, the popularity of these passive strategies has precipitated a “catch-22”: as more money is shifted to passive investing and indexing becomes more mainstream, the number of active investors is shrinking, and the very “crowd” that these passive investors rely on is disappearing.

Finding the Inflection Point: When Does Passive Investing Begin to Distort Market Prices?

As passive investing takes over a larger chunk of the market, there will come a time where the remaining ‘crowd’ of active investors is insufficient to interpret the fair market value of every security. This will give rise to market inefficiencies and pricing arbitrage opportunities which can once again be exploited by active investors for a profit. As explained by Morningstar’s vice president of research, John Rekenthaler, “the canary in the coal mine is when you see the better active investors starting to really beat the market… then we can say that pricing mechanisms may be breaking down, and the market is becoming inefficient”. This inflection point may be closer than we think, as, while investors withdrew a record $343 billion from active funds last year, thus far in in the first half of 2017 the exodus has shrunk to just $6 billion. Further, according to BofA Merrill Lynch, June marked the fourth straight month where more than half of large-cap managers beat their benchmarks (the longest streak since 2009). Along these lines, it can be argued that stock-picking opportunities increase as more money flows into passive funds, and that active investors may once again surpass their passive peers in the next bear market.
For further reading on this topic please consult the articles linked below:

https://www.wsj.com/articles/vix-sets-new-milestone-falls-to-record-intraday-low-1501021591?mod=itp&mod=djemITP_h for WSJ article (“VIX Sets New Milestone, Falls to Record Intraday Low”), saying that a key measure of market volatility set a new floor last Tuesday, falling to its lowest ever level in intraday trading
https://www.wsj.com/articles/how-quants-calm-the-stock-market-1500543001 for WSJ article (“How Quants Calm the Stock Market”), saying that quantitative funds are discovering surprises before they can create big stock-market moves
https://www.oaktreecapital.com/docs/default-source/memos/there-they-go-again-again.pdf for Howard Marks memo to Oaktree clients (“There They Go Again… Again”), saying that it’s better to turn cautious too soon (and thus underperform for a while), rather than too late, after the downslide has begun, making it hard to trim risk, achieve exits, and cut losses
http://www.businessinsider.com/hedge-fund-highfields-capitals-jacobson-on-quant-low-volatility-2017-7 for Business Insider column (“A $13 Billion Hedge Fund is Sounding the Alarm on One of the Biggest Trends in Investing”), saying Highfields Capital Management, a $13 billion hedge fund, has raised concerns about quant funds and passive investing in a letter to clients
http://www.barrons.com/articles/man-vs-machine-how-has-indexing-changed-the-market-1499491233 for Barron’s cover (“Man vs. Machine: How Has Indexing Changed the Market?”), saying the active/passive debate has obscured a major concern: will increased indexing impact the

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