If you think the migration of trillions of dollars into passive investing strategies has put volatility to sleep, you’re absolutely right, for the most part it has.
But what if blanket indexing isn’t the dream investment it’s cracked up to be?
What if the mad rush into passive investing vehicles merely casts a shadow over volatility?
What if passive investing is a black swan and it unleashes the volatility that crashes markets?
We’re going to find out – maybe sooner than later.
Passive Investing Is Indexing
Instead of trying to beat the market by being a stock picker, an increasing number of academics, Wall Street advisors, and product pushers are telling individual investors and some institutional clients that simply tracking the market by buying index funds is cheaper, less risky, and guarantees you won’t do worse than the market.
Of course, there’s no one measure of “the market.”
The big three indexes everyone follow to determine what the “market” is doing are the Dow Jones Industrials Average, the S&P 500, and the Nasdaq Composite.
Besides these there are plenty of others. There are indexes and averages that measure mid-cap market stocks, small-cap market stocks, sub-market indexes, industries, foreign markets, commodity markets, bond markets, and alternative market indexes.
And there are mutual fund and exchange-traded fund (ETF) products that track most of the indexes and averages investors might be interested in.
Buying an index fund, or diversifying by buying several different index funds is what passive investing is all about. You’re not an active stock picker, you’re a passive investor if you’re just buying the market, or markets, buying whatever funds track those indexes.
The passive investing trend is huge. And over the last few years, it’s gotten too big for its own good.
This Trend Is NOT Your Friend
While passive investing’s been around a long time (the first index mutual fund was launched by John Bogle’s Vanguard Group in December 1975), a lot of money’s been finding its way into the strategy since the financial crisis and the advent of hundreds of index ETF products.
Individual investors – many of whom became “self-directed” do-it-yourselfers – struggled through various market ups and downs. The 2008 financial crisis and market meltdown was the last straw for most, and they cottoned to the idea that being invested in the market, meaning buying the market, was the easiest and safest way to go.
With interest rates being manipulated so low for so long the stock market became the place to earn yield and make money as the market appreciated.
And appreciate it did.
The market, whichever benchmark you choose, is up around 260% since March 2009.
As the market continued higher, it drew in more investors – not stock pickers, mind you, but passive investors who wanted in on the ride.
Macro Risk Advisors calculates that there’s now $3.3 trillion held in passive investment vehicles, roughly split evenly between index mutual funds and ETFs.
And inflows are increasing. Almost $400 billion has flowed into passive investment products in the first half of 2017.
Those massive money flows, along with the bull market itself, has driven volatility to record lows.
Volatility always subsides – on the surface, at least – when markets are moving steadily higher.
But here’s why I say, “on the surface,” and what’s really happening that’s so dangerous…
Here’s What Millions of Investors Aren’t Seeing
The common measure of volatility in the market is the VIX, sometimes called the “fear indicator.” The VIX is an index itself. It’s a calculation of the “premium” cost of put and call options on the S&P 500 index.
Investors buy puts and are willing to pay up for them when markets start falling. They pay a lot for put options as markets are falling because put options are used to hedge portfolios and are a way to bet on the market going down.
As the price of put options on the S&P 500 goes up, the VIX itself goes up.
When there’s little need to hedge and no compelling reason to bet on the market going down, prices of puts on the S&P 500 index come down and the VIX comes down.
The bull market drove the VIX down in the first place, but massive flows into index products, which furthered the market’s rise, drove the VIX down to record lows.
So on the surface, as measured by the VIX, the market’s not volatile. There’s no fear factor.
But that’s all surface.
The VIX is only one measure… and it’s a measure of volatility of an index that hasn’t been volatile because so much money’s been thrown at it in terms of index mutual funds and ETFs.
Under the surface, there’s plenty of volatility. It’s just that investors, especially passive investors, don’t see it. That’ because they’re watching the big indexes, they’re watching the VIX.
Stocks that miss on their sales, or their revenues, or their earnings are hammered regularly. They are extremely volatile because they can drop 20% or more in a minute. That’s volatile.
Still, passive investors don’t notice. That doesn’t concern them. They’re watching the market indexes go up, that’s all they know. They’re just passively holding on, like good old “buy and hold” investors have always been told to do.
But hold on.
What if those so-called passive investors don’t follow the “buy and hold” script?
What if there’s a bout of volatility, what if there are successive bouts of volatility, which can be caused by any number of catalysts out there all the time?
What if hundreds of billions of dollars of indexed funds are sold by passive investors that suddenly become “active” because they remember that “buy and hold” doesn’t work if you don’t have years and years for crashing markets to recover?
What if selling by passive investors is the black swan no one sees flying right over us?
It’s going to happen.
Next week I’ll tell you what the triggers will be, what’s going to happen, and what you have to do to protect yourself from the dark clouds forming.