Market Review Q320: Should I Stay or Should I Go?
While large doses of monetary and fiscal policy got the rebound in stocks started, it was declining infection rates and economic recovery throughout the summer that kept the party going.
With progress stalling on both fronts in the fall, however, it’s a good time to reassess investment conditions. Liquidity is still ample, but momentum is slowing. Perhaps most importantly, several sources of potential volatility are imminent. That leaves investors with the challenge: Should I stay or should I go?
That decision of course involves tradeoffs, and those tradeoffs involve some assessment of risk. Although it has been quite a while now since the financial crisis in 2008, that event focused minds on topics like risk management and financial system fragility that had earlier received little but passing attention. Much like today.
Many of the insights came from physics, engineering, and other disciplines that have long histories of contending with systemic failure. Concepts such as "fat tails" and "nonlinearity" entered the investment vernacular.
After years of rising markets, however, and a rapid recovery from the selloff in March, discussion of these topics has faded from the public sphere as concerns about risk have abated. This is a shame because the structural risk elements are more relevant now than ever.
On this note, it is useful to take a short walk down memory lane to review some of those risk elements, specifically the conditions that can lead to nonlinear events. Michael Mauboussin set the stage with a research report on nonlinearity in 2007 that presciently predated the financial crisis. He described what has become a classic example of nonlinearity at work:
"On June 10. 2000, the Millennium Bridge opened to the public with great fanfare. London's first bridge across the Thames in over a century, it had a sleek design—the architect wanted it to look like a 'blade of light.' However, when thousands of people stepped on the bridge that day, it started to sway from side to side so much that people had to stop or hold on to the rails. Fearing for the public's safety, officials closed the bridge two days later and, following a retrofitting, it reopened in February 2002."
An important element of a nonlinear system is the critical point or threshold. Mauboussin describes the critical point as a situation in which "small incremental condition changes lead to large-scale effects". In the case of the Millennium Bridge that critical point was about 165 pedestrians. Under that threshold of people walking the bridge, there was no noticeable effect. When thousands of people walked across on the day it opened, it began to sway to such a degree that pedestrians had to grab the rail for support.
One small step
What happened? Ren Cheng answered the question in a separate report that included the same example of the Millennium Bridge: "'The lateral vibration, or 'wobble,' as it was called by many Londoners, was attributed to a 'positive feedback phenomenon,' whereby pedestrians crossing a bridge that has a lateral sway have an unconscious tendency to match their footsteps to the sway, thereby exacerbating it'."
Cheng used the example to investigate a more specific phenomenon, however. He had observed increases in both correlations and volatility in the stock market and wondered if the increasing popularity of passive strategies could explain the phenomena. He compared passive investing to the bridge:
"The Millennium Bridge example is analogous to the increased flows to passive strategies and the unwanted side effects of higher correlations and volatility ... Passive strategies reflect the independent investment decisions of many people, but in reality all passive investors are making the same investments (or steps)—just like the pedestrians walking independently on the bridge. Eventually, the bridge (i.e., equity market) starts to sway in the same direction (i.e., higher correlations), and then more violently in the same direction (i.e., heightened volatility) as more people walk (or invest) the same way."
Cheng makes a good case in highlighting the commonalities of the two systems. In both systems, individuals pursue their own optimal activity. In the case of the bridge, that is stepping in sync with the sway of the bridge. In the case of investing, that is investing passively. In both systems, individually optimized activity leads to collectively risky conditions.
Cheng concludes, "As the Millennium Bridge analogy helps illustrate, when a greater number of investors are choosing the same investments via passive strategies, there is less independent decision-making, and therefore less information discovery driving market prices." In other words, beyond a certain threshold, passive investing creates greater inefficiencies in the market.
Interestingly, Cheng raised his concerns about the impact of passive investing in 2012. Since then the share of passive investments relative to active ones has continued to grow. Although Cheng’s concerns have remained underappreciated, they have resurfaced recently from a couple of prominent voices.
Going, going ...
In 2018 Chris Cole at Artemis Capital Management published a report that highlighted the importance of liquidity. His broader point was that focusing too intently on liquidity prevents us from seeing a deeper reality underneath. The more specific point was that the increasing share of passive investing, at the expense of active investing, is increasing systemic risk. He forecasts, "A crisis-level drought in liquidity is coming between 2019 to 2022".
Mike Green from Logica Funds has also (frequently) discussed the structural impact of passive investing on the market. In an interview on MacroVoices he described, "When you move to a passive framework it becomes rules literally as simple as: Did you give me cash? If so then buy ..." In another interview with RealVision he described the influence of passives as providing "a giant, systematic player that reinforces momentum."
All of this serves to provide a useful perspective from which to assess investment opportunities. For traders and speculators, the "reinforced momentum" generated by passive investing creates a short-term tailwind that proves tempting.
For longer-term investors, however, the continued growth of passive management at the expense of active looks more like a nonlinear system that has exceeded its critical threshold. No longer does the balance of active and passive result in stock prices that reflect a semblance of fair value. Rather, the ongoing march of passive investing has served to stretch prices further and further away from fair value like a rubber band.
This highlights another interesting take. Eight years after Cheng expressed his concerns about the role of passive investing in boosting systemic risk, passive has continued to grow, and we are much farther removed from balance than we were then. Instead of becoming more concerned about downside risk and volatility, however, many investors are becoming less so.
One reason for this may be that the nature of nonlinear systems does not fit neatly into the mental models of risk that many people have. For instance, one common set of beliefs is that bad things happen as a result of bad behavior. While bad behavior is often involved, many times the more important cause is fragile systems. Certainly, this was the case in the financial crisis when a number of bad actors exacerbated problems but did not create the financial system in which they operated.
Another common belief is that passive investing is low risk. In narrow terms this is true. Passive funds have lower fees than active funds and have low risk of significantly underperforming their benchmark. However, passive funds do exactly the same thing regardless of whether expected returns are plus ten percent or minus ten percent. Cheng highlights, "As importantly, investors should not view the decision to invest solely in passive strategies as a way to minimize their risk exposure in a certain asset class".
In sum, one of the great challenges for long-term investors is to calibrate risk exposure to opportunity. It is important to remember that relationship changes over time. The particular example of Millennium Bridge and the general case of nonlinear systems provide a useful tool for envisioning that risk. This is especially helpful in an environment in which passive investing continues to shape the investment landscape and the risks it entails.