August 2020

There is a tide in the affairs of capital markets, which, taken at the flood, leads on to fortune. On such a full sea are we now afloat, and we must take the current when it serves, or lose our carefully constructed investment portfolios.

Let’s start with the macro.

Macro - Is There a Big Short Opportunity Against Passive Today?

This was the question that initially motivated this research. I see two potential areas of concern.

First: will Boomers sell retirement assets en masse, triggering forced passive selling and a market meltdown?

Probably not. Industry-standard models from McKinsey and Cerulli assume that small net outflows from Boomers over the 2020s will be offset by mid-single-digit returns in the public markets. NBER president Jim Poterba suggests that withdrawals will likely be modest because demographic changes are slow and predictable. The GAO adds that most financial assets are concentrated in the hands of wealthy households who will feel little pressure to fire sale assets. The IRS does force retirees to sell retirement assets to make required minimum distributions (RMDs); however, the SECURE Act of 2019 deferred the RMD age from 70.5 to 72 years old, keeping more of these assets in the markets. Perhaps a vanilla market crisis could convince retail investors to panic, but that wouldn't be driven by the retirement-to-passive pipeline.

Second: will private equity funds steal enough allocation from passive public equity funds to impact the public markets?

Perhaps on the edges, though it seems unlikely to be cataclysmic. For reference, the largest 200 US defined benefit plans already allocate ~10% to private equity, and Australia’s A$2.7 trillion superannuation retirement scheme allocates >5% to unlisted equity. Public equities would lose assets on the margin, but private equity funds might buy some companies directly from the public markets. Should the public markets impact be severe, one would also assume that Vanguard et al. would lobby to shift the system to maintain AUM in public equities (e.g. by increasing the RMD age).

In short, there are potential icebergs, but they aren’t definitively on today’s path. If you're interested, it's worth monitoring elderly retirement withdrawals, the white-collar unemployment rate, and Target-Date Fund allocation plans.

Micro - Finding Alpha in a Passive World

So, fundamental investors should focus on strategies that benefit from an increasingly passive environment.

One argument is that options are structurally mispriced. Steady passive inflows and falling interest rates have led to a demand for short vol strategies to generate income. Meanwhile, the shift from 90% invested active funds to 100% invested passive funds should, theoretically, reduce the amount of trading liquidity available day-to-day. If the market is overwhelmingly short calls and puts in an increasingly volatile, index straddles could be underpriced. I would direct you to Mike Green of Logica as well as Marko Kolanovic of JPMorgan for research on this market structure theory and related strategies.

Another approach is for private equity firms and activists to take advantage of lax governance by passive funds. Blackrock, Vanguard, and State Street (the large passive owners) and ISS and Glass Lewis (their voting advisors) have voted Yes to virtually every proposed merger for years.

Fig 1. Percentage of mergers approved by Blackrock, Vanguard, and State Street 

We could enter an age of “take-unders” instead of “take-overs.”

Blackrock publishes their voting record each year, confirming the intuition that growing passive funds may have difficulty scaling governance judgments. I think, cynically, that corporate governance abuse may generate significant alpha going forward.

A third approach is to study which investors drive the majority of share repricing and how those investors interact with passive indexes. Some investors are much more important than others in driving stock prices up and down.

Fig 2. Impact on US equity prices by type of owner

You can think of each stock following an ownership path in which certain investors own it at various stages. In the private markets, we know this as Seed, Series A, Series B, etc; I'd argue there are analogous stages in the public markets. The most obvious are index inclusion and exclusion, published for all to see by providers like S&P and Russell. I believe you can segment investor categories to identify, with high probability, which types of investors are most likely to buy or sell your stock after you. No two ownership paths of successful stocks are exactly alike, but the similarities can be striking. Koijen and Yogo (who created Fig 2) have announced that they have an important update coming this summer on this topic. I won’t steal their thunder from what they've emailed, but I do recommend following their research. At the time of this writing, the SEC has just proposed new disclosure standards for 13-Fs, so you should follow those updates as well.

I’m a fundamental investor at heart, but I've come to believe that the best investors do as much fundamental diligence on the capital flows impacting an asset as the asset's underlying cash flows. Passive flows don't seem likely to crash markets in the near-term, but this changing environment should create opportunities for the next generation of fundamental investors.

This situation is still unfolding, and I'm sure there are facets of it that I've overlooked. Feel free to email me or message me on Twitter if you have a pointer to an interesting reading or a response to share.

Special thanks to the research staff at the NBER, McKinsey, Cerulli, and Vanguard for their help with this piece and to Mike Green of Logica for his work on target-date funds and retirement flows.