From Mike O’Rourke at Jones Trading
The Most Crowded Trade in History
In the past we have talked about the rise of “blind buyers.” They represent those who have transitioned from looking at equities as shares of ownership in companies and businesses to equities simply as an asset class. As such, they place their equity investing on autopilot in passive and index products. Among others, the group represents individual investors, institutional investors or computerized investors trading correlation and asset allocation models. It is far less time intensive for an individual investor to buy an index fund rather than research stocks or active managers. It is probably more cost effective to have a quant build a model to trade market relationships than to hire a team of analysts to delve deeply into individual companies.
Monetary policy which has been pinned at aggressively easy levels has only reinforced this transition to viewing equities as an asset class. Stagnant policy has minimized investors’ need to make decisions about the path of interest rates. Nowadays, market participants generally share similar views on the path of policy going into and coming out of each economic release. There is not much variation on where interest rates will be in the future and how will they influence a company’s cost of capital. The Fed Put and the accompanying liquidity wave have encouraged investors to simply buy the asset class as a whole. The permanently easy monetary policy has removed an important market variable that goes into the decision making process that creates a two sided market.
Historically, research has indicated that most active managers underperform the index on an annual basis. That being said, we can’t help but to recall legendary mutual fund investor John Neff’s memoir about his time at the helm of the Windsor fund. Neff talked about the pain of underperforming the S&P 500 by 6.7% in 1971 and 8.8% in 1972. Later, his 10% outperformance in 1973 offered no solace because the fund lost 16.8%, which followed the 25% loss in 1972. In 1975 and 1976, Neff posted gains of 54.5% and 46.4%, outperforming the S&P 500 by 17.4% and 22.6%, respectively. There is no doubt Neff is exceptional and an outlier, but today’s environment would never allow such brilliance to emerge.
According to Morningstar, US equity active managers have endured $179 Billion of outflows, while US equity passive funds experienced $110 Billion of inflows over the past year. During the past 18 months in which the market has risen 10%, US equity fund assets have shrunk by 1.5% according to Morningstar’s data. During the same period, passive US equity funds have grown by 19%. The mix of US equity mutual fund assets has gone from 63% active and 37% passive 18 month ago to 58% active and 42% passive today. That is a strong shift over such a short time period.
Instead of looking for manager’s and investment opportunities to beat the market, investors are opting to be the market and are likely creating the most crowded trade in history. Stagnant monetary policy fosters a groupthink outlook. The Fed Put prompts the same positioning. Computerized programs trade correlations and relationships established during an extended period of abnormal policy. Active managers continue to retrench as the market diverges from the fundamentals, but the blind buyers continue to participate – it does not matter if the market is 10x, 15x, or 20x earnings, they buy for one reason, it is the market.
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