We’ve witnessed the quickest, most turbulent bear market, followed by an equally speedy recovery. Over the past six months, the S&P 500 index has gone up by 47%. Throughout this time one thing has remained constant — heightened levels of volatility, and an ever-increasing lack of liquidity. There’s some strong evidence that leads us to believe that those two factors are not a product of the post-crisis market structure - on the contrary, it seems that they led to a large part of the recent rally. For the past few months, the S&P volatility index managed to stay above 25, except for a few trading days. When we look back a couple of years, this level is concerningly high.

Why are we seeing these volatility levels?

Some believe that this has been caused by the crazy speculative trades initiated by Robinhood traders who can be found bragging about their losses over at r/wallstreetbets[1].

While that is definitely a part of the equation, we don’t believe that bored college students have the financial capacity to actually move the market, no matter how bold their levered trades are.

A lot of factors suggest that the new high volatility environment stems from a structural change in the markets — the move to passive investing.

The underlying factor — demographics

Different surveys have demonstrated the tendency of younger investors (people aged 18–35) to invest the majority of their capital in index-tracking ETFs. Older investors, on the other hand, are still reluctant to ride on the passive wave and keep their holdings in actively managed funds. With every year passing, however, some of them reach retirement and start liquidating their investments. The redemptions are always a drag on active fund performance, since they force the managers to sell their favourite stocks, and cover shorts at inconvenient times, and that only exacerbates the problem. This feedback loop led to unprecedented outflows out of active managers. The migration from active to passive has only been accelerating in the past five years and it has led to the total dominance of passive investing.

In 2019 alone, actively managed equity funds had outflows of $41 billion, while passive equity funds saw an inflow of $162 billion.

According to a paper[2] released by the Federal Reserve Bank of Boston, passive funds now make up 48% of AUM in equity funds, up from 14% in 2005.

“So what…”, you may think, passive investing leads to a better risk-adjusted return, right? Well yes, but actually no. At least not for too long. To cite the favourite sentence of the SEC:

Past performance is not indicative of future results

Like every other strategy out there, popularity might also cause the demise of passive ETFs. The underlying theory behind passive investing is the efficient market hypothesis. The case can be made that if every market participant is actively trying to take advantage of mispriced equities, prices start reflecting all available information. That can never be achieved to 100%, but it can definitely get close. In order for the theory to hold up, there has to be a competitive active management field, constantly trying to squeeze every decimal of alpha that exists in the market.

If, however, 50% of all investors are passive and do not care about valuation, arbitrage, and all of those “useless methods”, the efficient market hypothesis begins to crack. We’re seeing this exact thing right now, with large-cap US equities, which are priced way above any reasonable model or expectation.

The fact that when fewer market participants are involved in active price discovery, markets tend to behave in strange ways tells only half the story.

The biggest concern caused by the massive influx of capital into passive investments is the constant level of high volatility, and the reduction in liquidity, especially in the stocks with the highest market capitalisations.

While everyone is commenting on how the Fed is flooding the market with liquidity, perhaps that’s just not reaching the equity markets. Considering that we are at the same level on the S&P500 as in February, now the liquidity is nowhere to be found.

We believe that the reason for the unprecedented V-shape recovery that we witnessed in US equities is mainly caused by the lack of liquidity caused by the growing share of passive investors on the market. When thinking about passive ETFs, we realise that they are not actually passive. They are just like active managers, but with crazier rules. For instance, most passive investors just hold onto their shares while the market is down, and sometimes even purchase more. This means that the index-tracking funds are almost always in a position of net capital inflows and they have to keep buying shares. One question quickly arises — if no one is selling, who are they going to buy from? That’s exactly how prices explode. When the available order book for the biggest company — Apple was at $2.5 million, in a day in late August, and considering that on a good day, $1 billion could flow into the iShares SPDR S&P 500 ETF, that means that the asset managers of the ETF are obligated to buy 60 million dollars of Apple in a single day. Well, what happens when there is $2.5 million worth of shares for sale at the current price, and you need to buy $60 million? Easy — you just raise the price to entice more sellers.

This correlation between the discontinuous fashion in which the market operates and the rise of passive investing has also been discovered in a couple of studies[3].

The results show that arbitrage activity between ETFs and the underlying securities leads to an increase in stock volatility. Moreover, consistent with a deterioration of pricing efficiency, ETF ownership and flows appear to make prices diverge from random walks, both intraday and daily. These findings lend support to the conjecture that liquidity shocks in the ETF market are propagated, adding a new layer of non-fundamental volatility.

Long story short, the ever-increasing share of passive investors leads to an increase in market fragility, both to the upside, and the downside.

The solution

In this new market environment, when daily price moves are exacerbated by a lack of liquidity and the huge buy/sell orders from passive asset managers, the only way we see to reduce portfolio risk and drive a positive alpha return is to be long volatility. Unfortunately, long volatility strategies are not as easily applicable to a retail portfolio as in a professional setting, but we need to see at least some tail-hedging applied by retail investors, or the risk of a go-to-zero event is just too high. If we see the share of passive investors increase even more to above 50%, the levels of volatility that we might experience could change our perceptions of risk and break a lot of the existing models in the space. In the post-2020 world, we’ll be sailing in uncharted territory as, evidently, there’s a new market structure, and when it comes to market shocks — we’ve seen nothing yet.

[1] https://www.reddit.com/r/wallstreetbets/

[2] Working Paper | SRA 18–04 | August 27, 2018. Last Revised: May 15, 2020 The Shift from Active to Passive Investing: Risks to Financial Stability? Kenechukwu Anadu, Mathias Kruttli, Patrick McCabe, and Emilio Osambela

[3] Working Paper | Do ETFs increase volatility? Itzhak Ben-David, Francesco Franzioni, Rabih Moussawi