Following 7 years of underperformance, 2016 is the year where hedge funds and other active managers have been finally been hit with the long predicted mass withdrawals – leading to a spike in prominent hedge fund closures, most recently that of Perry Capital – which in recent months have spiked to the highest level since the financial crisis, paradoxically just as the market is on the verge of making new all time highs again.
And with activist central banks doing everything in their power to prevent any substantial risk-asset declines in order to avoid failing on the “weath effect” mandate, it was only logical that as money flowed out of active funds it would enter passive: something which has not only been happening for the past several years, but which according to BofA has now hit a record level.
As BofA’s Savita Subramanian reports, over the last several years, we have observed an accelerating trend of flows out of active funds and into passive vehicles. Price sensitivity of investors to fees, coupled with poor performance trends, have conspired against active funds, and year-to-date flows out of active have reached a post-crisis high.
As the chart below shows, the current year outflows from active funds have now surpassed a record $200 billion, with the bulk of cash outflows shifting to much cheaper (and better performing) passive funds, though as BofA notes, flows have slowed since last year suggesting that there may be a broader cash outflow from the equity asset class, as increasingly more Americans retire and pull out of the market entirely.
So what is the best way to trade this ongoing rotation? As we first pointed out in 2013, and subsequently reaffirmed in June, doing the opposite of what the few remaining active investors continues to be a winning strategy. BofA confirms:
Amid this trend, a strategy of buying the 10 most underweight stocks by active funds and selling the 10 most overweight stocks at the beginning of the year has generated 13ppt YTD (following 13ppt and 18ppt of alpha in ‘15 and ‘14, respectively). Admittedly, returns from positioning have been muted in recent months, but with two-thirds of US AUM still in actively-managed funds, we see more to go in the active to passive rotation. Positioning will likely continue to matter.
Here is the proof that year after year, going short the most loved and short the move popular stocks, generated incremental alpha.
Finally, for those who wish to test out this strategy, here is the list of Top 10 most and least exposed stocks to active funds. Remember: go short the left column, and long the right one.
One last observation: this accelerating transition from active to passive management will end in tears, as passive management only works as long as the rising tide keeps lifting all boats. Once that ends, the party is over, and as Julian Robertson warned yesterday, there will be a need for someone who knows how to, gasp, short. By then, however, such anachronistic individuals may no longer exist. For those looking for the culprit for this uniform levitation across all asset classes, look no further than those who continue to inject some $200 billion in liquidity every month, making sure that everything goes up at the same time, and worse, keeps zombie companies alive and kicking, in the process crushing countless shorts.
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