“obviously you’re buying everything in proportion to its market cap and therefore you’re not changing anything.”
This statement has an implicit assumption that liquidity scales with market cap.
Because this is not true, and the biggest stocks get the biggest passive inflows, the biggest stocks tend to rise the most over time and they become much more volatile than the mid caps.
I’m just simplifying your argument here, feel free to let me know if I missed something critical.
Mike, your work on passive has been really eye opening for me. I think your effort to bring awareness is admirable and will hopefully make its way to better policy making (fingers crossed). Regardless, you make the concept easy to understand, which should help spread the word and get the right people thinking about the potential ramifications of passive selling.
One question to ask though…how much has passive affected major European and Asian equity markets?
It has LESS of an impact on European and Asian markets because it is much less penetrated. There are a few exceptions to this -- Australia, for example, where indexing has become the national pasttime due to superannuation funds. There we can see the obvious impact as the largest stocks in the index are also trading at absurd valuations (their largest bank is 2x the multiple of JPM for example).
if we ignore for the moment, that roughly correct valuation of public equity should be inherently good and hence your argument that passive has ruined the stock market, it seems the takeaway for me if we purely look at the best strategy to beat this market is that sharp traders should buy even more of the biggest stocks, which exacerbates the problems even more. I guess this already happened with momentum/growth funds. Any thoughts ?
Great post Mike! Maybe you’ve discussed elsewhere (if so please share), but what is your proposed solution for this other than breaking up blackrock/vanguard or ending default enrollment in tgt date funds for employees (the majority of whom don’t care about any of this and are only focused on “low fee”)? The tradFi active industrial fund complex did this to themselves after getting fat on high fees/minimal value during the 80s-00s so how do we find balance? A technologically superior/cheaper alternative SMA type product like Frec?
A bit of a sidetrack, I recall you explain the '22 spx decline as a simple target date fund rebalancing out of equity into fixed income again and again, as the entire curve got smoked.
Further, from this week's note: "...but we can acknowledge that Fed interest rate policy that inflates the value of bonds will (all else equal) inflate the value of equities"
So is it reasonable to expect a very bullish equity dynamic to follow collapsing rates? Or do you think labor weakness can eventually flip the net contribution equation negative enough to win that tug of war with the rebalance channel?
The caveat being that bond prices are determined by forward expectations of rates and current bond pricing already reflects aggressive fed rate cuts. If the Fed beats these expectations, then "yes" we will see a positive equity impulse. Hence the importance of the debates around Fed cuts.
“obviously you’re buying everything in proportion to its market cap and therefore you’re not changing anything.”
This statement has an implicit assumption that liquidity scales with market cap.
Because this is not true, and the biggest stocks get the biggest passive inflows, the biggest stocks tend to rise the most over time and they become much more volatile than the mid caps.
I’m just simplifying your argument here, feel free to let me know if I missed something critical.
Mike, your work on passive has been really eye opening for me. I think your effort to bring awareness is admirable and will hopefully make its way to better policy making (fingers crossed). Regardless, you make the concept easy to understand, which should help spread the word and get the right people thinking about the potential ramifications of passive selling.
One question to ask though…how much has passive affected major European and Asian equity markets?
It has LESS of an impact on European and Asian markets because it is much less penetrated. There are a few exceptions to this -- Australia, for example, where indexing has become the national pasttime due to superannuation funds. There we can see the obvious impact as the largest stocks in the index are also trading at absurd valuations (their largest bank is 2x the multiple of JPM for example).
if we ignore for the moment, that roughly correct valuation of public equity should be inherently good and hence your argument that passive has ruined the stock market, it seems the takeaway for me if we purely look at the best strategy to beat this market is that sharp traders should buy even more of the biggest stocks, which exacerbates the problems even more. I guess this already happened with momentum/growth funds. Any thoughts ?
Unfortunately, I think that is right.
Great post Mike! Maybe you’ve discussed elsewhere (if so please share), but what is your proposed solution for this other than breaking up blackrock/vanguard or ending default enrollment in tgt date funds for employees (the majority of whom don’t care about any of this and are only focused on “low fee”)? The tradFi active industrial fund complex did this to themselves after getting fat on high fees/minimal value during the 80s-00s so how do we find balance? A technologically superior/cheaper alternative SMA type product like Frec?
Keep writing Mike!
A bit of a sidetrack, I recall you explain the '22 spx decline as a simple target date fund rebalancing out of equity into fixed income again and again, as the entire curve got smoked.
Further, from this week's note: "...but we can acknowledge that Fed interest rate policy that inflates the value of bonds will (all else equal) inflate the value of equities"
So is it reasonable to expect a very bullish equity dynamic to follow collapsing rates? Or do you think labor weakness can eventually flip the net contribution equation negative enough to win that tug of war with the rebalance channel?
All else equal, 'Yes"
The caveat being that bond prices are determined by forward expectations of rates and current bond pricing already reflects aggressive fed rate cuts. If the Fed beats these expectations, then "yes" we will see a positive equity impulse. Hence the importance of the debates around Fed cuts.