Change in Market Construction and Unforeseen Risks

Peter Whiting

ARCO Investment Management

Change in Market Construction and Unforeseen Risks

Given the ever-changing landscape and participants, the construction and functioning of equity markets has always evolved over time. It’s a natural occurrence. However, with the events post the pandemic coupled with the monumental change that has occurred regarding how people invest over the past decade or so, it’s probably a good time to assess “where we are.” The fact is, while commentators still talk in the age-old language of “fundamentals” when describing market moves, given my long experience in analyzing flows, I sense there’s something much more structural afoot.

Index/passive/Exchange Traded Fund (ETF) investing has exploded in recent years. Of course, this type of investing has a valid role in markets, but in a zero interest rate world with endless liquidity and the perceived protection of the central bank “put”, almost free, cheap returns (beta) is the new consensus equity investment method. We all know the direction of this trend, but any negative consequences that could arise appear to be almost totally ignored.

For example, is there a tipping point where the lack of true active investment community, one that invests based on fundamentals, effectively kills the traditional price discovery function of the market? Is there a tipping point where the notion of a stable, broad investment method actually sows the seeds of market instability? What risk does that pose for investors or, more importantly, is the average person even aware?

The discussion about impacts of various passive participants and products has always been around in different forms, but with a dominant, healthy active funds management community based on fundamental factors, there was always “another side” to their liquidity needs. Thus, the impacts of “non-thinking” money largely went unnoticed in a world where fundamental analysis was the edge. However, the words “hated” or “nervous” bull markets became outcomes of these trends moving the equity investment landscape slowly off its traditional fundamental access point. Human brains always struggle and anxiety builds when things do not make sense which some see as an outcome of this move to passive investing. Unfortunately, opting out when cash and bonds are virtually zero is a hard call for individuals, but professionals must continue to play.

Rather than try and identify participants in precise percentage terms, it’s probably best to focus on the trends and how these participants’ activities relate to each other and the overall functioning and outcomes of markets. For the purposes of this discussion I have left out High Frequency Trading (HFT), as despite their large intraday volumes, by effectively providing a market-making function they likely only fuel daily trends rather than structurally change them. I have also given thought to the “Davey Day Trader” phenomenon, but at this point will mark it as faddish and not a major influence on the overall pie. That said, episodes like the recent Hertz experience (Hertz declared bankruptcy and the impact of day traders saw the share price inexplicably soar before subsequently cratering) does tweak my never-ending curiosity regarding the psychology of markets. But that piece will wait for another day!

No doubt the four largest contributors to the change in equity markets are as follows:

1. Growth in Passive, ETF’s and the return of Structured Products

2. Excessive and continual central bank liquidity

3. Impacts of financial repression

4. Shorter and shorter performance measurement periods

These trends all weave together with the ever-increasing pool of central bank liquidity (which we know doesn’t really make its way out to main street, but sloshes around in the canyons of Wall Street) to leave us at the point we are today.

Make no mistake this is a very complex and almost emotional topic in investment circles.

Most sense these dynamics, but the size and dimension has surprised. Having to throw out and pivot away from a lot of previously proven investment skills or adding non-fundamental factors into the investment process does not easily fit with most active fund manager, let alone asset consultants who dole out the money. The whole issue can be psychologically frustrating and exhausting for traditional players. It almost seems easier to treat it like many other cycles and phases we have seen in markets, and many hope it is transitory and will cyclically flame out, especially given the poor performance of the average active manager over a long period. However, if anything, it seems to be getting stronger.

To be clear, I don’t believe that poor performance, on average, of the active investment community is because traditional thinkers have become dumb or had a collective lobotomy. It just appears that, while fundamentals will always win in the long run, we are in a paradigm where the time sequencing of the share price to company fundamentals relationship has changed because of this modern construction of participants and products.

Growth in Passive and ETF Investing

The current statistics globally suggests that passive investments comprise circa 45% of FUM. This is an enormous change in a relatively short time frame. Importantly in my opinion a lot of the fundamental, active fund managers that remain can be described as “Benchmark Aware” which simply means that they somewhat mimic the index. Factor investing, especially using momentum, is an extremely fast growing and popular strategy. Combining factor with traditional quantitative type products means that momentum investing has a huge influence on markets. A simple way to sum this up is that market capitalisation (size) begets market capitalization. Now add a heavy dose of momentum and it’s easy to see how we get the unprecedented narrowness of today’s equity markets. Remember this all has nothing to do with valuation.

ETF’s just exaggerate the trend as they are continually using the same stocks over endless products. Last time I looked Apple was in 279 ETF’s. Is it any wonder its market capitalization has now sailed thru two trillion dollars? Remember, ETF’s are more about “have a hunch buy a bunch” correlation-type investing, rather than anything to do with valuation. Older generations hold more active products but are sellers into retirement, while the newer generations use Index/passive/ETF’s etc., which just fuels this argument. So what is the real percentage of investors all effectively doing the same thing? I would suggest its dwarfs what one would think and hence leading to the notion that the stock market has become a product market.

Financial Repression refers to the incredible amount of “Bond Refugees” essentially moving to the equity bucket harvesting stocks for income, almost akin to locusts. This somewhat perversely leaves investors buying bonds for capital growth and equities for income. The dark art of Structured Products has also seen massive growth in producing, theoretically, an equity product with bond like risk characteristics. While not necessarily a greed game like sub-prime, it is an unintended consequence of financial repression forcing investors who need to obtain a certain income way out on the risk curve. Using these products allegedly dampen the risk. Whether it be risk parity, target volatility, CTA’s or any type of manufactured income products, dissecting as to whether they are a wick or additional fuel is almost irrelevant. The important part to understand is that firstly they are showing to be more likely in sync with market capitalization and momentum attributes discussed above. Secondly their activity has nothing to do with valuation, they are totally formulaic and do not care about prices paid for stocks. Only time will tell if excessive leverage and potentially flawed risk analysis will be problematic down the road. However, 37 years in markets assessing risk tells me problems will occur.

Reversion? Or a new normal.

Humour me for a second. Given the backdrop I have painted above, replay the blowoff rally at the backend of 2019 and early 2020 that everyone seemed to scratch their heads about, followed by the Covid19 led high speed fall in markets to March lows. How would this type of setup play if we were another 20%+ greater in the index/passive direction? Of course, we all do not have to really think about that as we blindly assume the central bank put fixes all, just as it did again in March. Maybe one day they will be out of bullets.

The contrarian in me smells that this should all add up to opportunity. But so far, that road is littered with carcasses, and some pretty famous ones at that. With performance measurement periods having shrunk to such a short time frame, increasingly fewer managers are willing to stomach the job risk and allocators the volatility to see if there is a chance for a big payday. Assumptions that central banks are out of bullets get swamped with “whatever it takes” and “more in the tool kit” talk continuously. MMT is virtually already in play! Zero interest rates in theory effectively means you can make an asset worth almost anything. Almost free Beta with a central bank put is going to be hard to shake as the consensus playbook. To go against the trend, most people like to have a catalyst. Ironically, by the time these things get identified the miss-match in liquidity may have already seen the horse well and truly bolted.

With these mostly overlooked risks, “where the crowd isn’t” should make up a portion of one’s equity portfolio. Uncorrelated returns and the areas of the market that are still suffering from lack of index inclusion or size are probably the best opportunities.

The notion of value vs growth is not really the true debate. That can easily lead those unable to perform quality research to buy companies that have impaired business models/bad balance sheets which are essentially “value traps”. However, if you look deeper there is a thematic of “Haves and Have Not’s” based more on market capitalization

To sum up, again humour me with the math and let us look at a circumstance where this trend continues unabated and central banks run out of ammunition. Simplistically, in theory, if the market outside of the important functioning of raising capital becomes comprised 90% of similar investments (passive, momentum, etc.), then the effect at an unseen juncture point could be ludicrous. In such a case an unforeseen event could theoretically result in 90% of investors trying to exit at the same time. That would be a level of volatility that nobody would enjoy. In fact they would probably have to shut the markets down!

Was the speed of the March correction a lens to the future? What can equity markets learn from the Fed having to arguably go outside its mandate and buy corporate bonds to enable a traditional very deep and liquid market to actually function?

In my opinion, the subtlety of this modern market construction probably means that the equity landscape will never be classified the way I have described above by mainstream commentators.

As we slowly put Covid19 behind us and use excess liquidity and low rates to again buy into a “Synchronized Global Growth Recovery” people will not like hard topics affecting such as this affecting their parties! The topic may be seen as “move on nothing to see here” as the winners will own the marketing and commentating airtime.

But as a person that analyses risk for a living, I would rather open this debate now, rather than talk about it in the rubble of the aftermath.  

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Peter Whiting
Co-Founder and Co-Portfolio Manager
ARCO Investment Management

Peter is co-Portfolio Manager at ARCO Investment Management. Prior to co-founding ARCO IM in 2008, Peter served as a Managing Director in the Equities Division of Citigroup Australia and as an Executive Committee member.

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