When The Going Gets Tough, The Tough Get Active

When The Going Gets Tough, The Tough Get Active

The recent popularity of index-tracking ETFs and passively managed mutual funds has coincided with one of the longest bull markets in history. But this trend conceals a dysfunctional market where company fundamentals are being ignored and prices distorted. How can Active Fund Managers benefit from the inevitable backlash?

Index Funds have seen phenomenal growth since the recession of 2008. At the time of the last financial collapse, Index ETFs accounted for 6% of the Fund Market, with Index Mutual Funds at 9%. Today, they make up 17% and Index Funds at 18%. This massive expansion in the passive sector is one of the most significant investment trends of the last decade.

As Frank Holmes recently wrote in Forbes: “The seismic shift into indexing has come with some unexpected consequences, including price distortion. New research shows that it has inflated share prices for many popular stocks. A lot of trading now is based not on fundamentals but low fees. These ramifications have only intensified as Active Managers have increasingly been pushed to the side.”

Trevor Neil, a Senior Analyst at Quantlogic and Europe’s leading quantitative analysis expert, says: “The problem with the increased popularity of cheap and easy passive index funds, is that too many Fund Managers have also been hugging their benchmarks to stay on top of the market. They have become passive by default.”

The end of the passive gravy train

True to the nature of index investing, a passive portfolio that rides the wave of a broadly successful market will also mimic the depths of its decline. A vast pool of money has been pouring into companies that are indexed, irrespective of their individual performance. But imagine if the whole market was passive – there would be no shift in asset prices at all. In fact, the passive market relies on the active market to establish true value.

Mr. Neil says: “Active Fund Managers can deliver the best value for their clients by making intelligent investment choices based on their own unique insights into the market. An index-tracking ETF cannot do that, so this is where the real value of Active Fund Managers comes into play.”

Nicholas Scarr, CEO of Quantlogic, says: “Index tracking creates price distortions which are bad for the market, for Fund Managers, and investors. How smart is it to get locked into General Electric and be able to do nothing about it whilst its market capital halves in 12 months? How smart is to be feeding a market bubble without the ability to do anything except liquidate the whole market at once?”

With 35% of the market now passive, the market has become much more sensitive to liquidity issues. Today there are more ETF’s than individual stocks, with the number of total shares traded being reduced by share buybacks. This significantly raises the risk of a dramatic and chaotic reversal.

As Mark Carney, Head of the Bank of England, recently stated: “The risk of a sharp and disorderly reversal remains given the compressed credit and liquidity risk premia. As a result, market participants need to be mindful of the risks of diminished market liquidity, asset price discontinuities and contagion across asset markets.

 

Do algos have the answers?

Another major market trend of the last decades is the rise of algorithmic trading. If the markets can be reduced to ones and zeros surely a computer will be more successful at predicting trends than a Fund Manager, with all their human weaknesses.

Not according to Richard Bookstaber, author of ‘The End of Theory’ and a leading risk manager who worked for Morgan Stanley and Bridgewater

Associates. “Human judgment coupled with the mathematical rigor of computer modeling can make better decisions,” says Bookstaber. “But when humans put blind faith in quantitative models, that’s dangerous.”

“A crowd isn’t the simple sum of its parts,” Bookstaber says. “Individuals, acting as a group, behave differently than in isolation. Think of how a throng moving toward a door can suddenly start – or stop – shoving to get in or out. Financial markets do that, too.”

A classic example of these ‘outliers’ that computers find hard to fit into the restrictive framework of their models, is the housing market. US property prices had gone for decades without a severe correction, that is until they collapsed dramatically in 2006-07, helping to set off the last financial crisis.

In 2015, Paul Tudor Jones of Tudor Investment summed up a sensible approach to the new algo landscape: “No man is better than a machine, and no machine is better than a man with a machine,” he said.

Rediscovering price discovery

Price discovery is a vital function of any marketplace. Without it, the market would cease to function. The recent prevalence of index investing may have started to obscure this function, but it is the nature of the market to flush out price distortions and imbalances.

Mr. Neil of Quantlogic says: “One obvious and critical element of establishing the value of any stock is to look at the buying and selling of that stock by active market participants. This enables you to view how the market has arrived at a consensus value for the company.”

To this end, the team at Quantlogic has developed a solution called Edge™, which enables Active Fund Managers to see price distribution levels of individual stocks in one unique and simple interface, giving them actionable information for better investment decisions.

“Edge distills decades of quantitative market research and makes that information accessible,” says Mr. Scarr. “It democratises the best techniques of algorithmic investing, putting the Fund Manager in the driving seat so they can make informed choices based on real market insight.”

 

Emini S&P 500

Edge in action

 

Software systems like Edge will no doubt become more widely used by Fund Managers as the recent era of low volatility, momentum-driven markets come to an end.  Investors, will seek out active fund managers who are able to beat the market, as the passive investing gravy train splutters to a halt.

Mr Scarr said; Our ambition is to provide the Active Fund Management Industry with the right insights so they can stage a fightback against passive funds.  We believe this fightback is long overdue.

Request a free trial click here.

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nscarr@quantlogic.com

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