The Passive Investment Bubble

"A turkey is fed for 1,000 days by a butcher, and every day confirms to the turkey and the turkey's economics department and the turkey's analytical department that the butcher loves turkeys, and every day brings more confidence to the statement. But on day 1,001, there will be a surprise for the turkey ..."
-- Professor Nassim Nicholas Taleb

The Pandemic

The COVID-19 pandemic is by far one of the toughest problems we have faced as a people over the past two decades. SARS, MERS and Ebola were severe epidemics, but the necessary containment procedures put in place in those times were sufficient to arrest the spread and stop these epidemics from turning into widespread pandemics. A lot has changed since which has radically altered the way we conduct business and invest.

Could this be the next Black Swan?

I am not trying to be an alarmist, neither am I an epidemiologist and if this passes without any serious consequences, we will all rejoice. However, given the open-ended and unknown nature of this pandemic, we have to consider every possibility in the realm of infinitesimal but non-zero probability outcomes.

Globalization

First, globalization. Since the early part of the 21st century, markets across the world have become deeply integrated, the movement of goods and services has become seamless. Ergo, the invisible all-pervasive hand of "free market" ideologies has been working like a charm. It has created tremendous wealth, taking millions out of poverty and destroyed supply chain barriers. As a result, the world's GDP has been growing steadily (barring the '08 subprime shock) and importantly, China has become an industrial juggernaut, the world's manufacturing hub, and in less than 2 decades, ascended to become the 2nd largest economy in the world. The proportion of China's GDP in the world economy rose from 4.4% in 2002 to about 19% currently (what has happened in terms of climate change is a different issue and I'll save that for another time).

China Shut-down

With that said, the current COVID-19 pandemic has pretty much shut 50% of the Chinese economy - or 9.5% of the world's GDP contribution is currently at a complete standstill. While white collar workers are working from home, the labor intensive factory work-force is still quarantined. The deadly virus has spread to South East Asia (Hong Kong, Singapore), Eurozone (Italy, Spain, Switzerland, Croatia), the Middle East (Iran, Kuwait, Bahrain), Pakistan, Latin America (Brazil), Australia, and the US. The world's supply chain, an intricately connected web of suppliers and consumers, is crippled. If the spread worsens, people globally will work remotely, production will slow and will result in a supply shock. There will be shortages everywhere. Econ-101 suggests that this will lead to inflation, demand destruction will ensue, thus causing a recession.

Investors will run for cover and flight to safety will most likely be the "herd" trade du jour. Except that this time around, a "liquidation" will be disproportionately disorderly .. and here's why.

Historical Perspective

Since the 2008 subprime mortgage crisis, central banks across the world have engaged in loose monetary policy. They have rolled out quantitative easing operations, have reduced interest rates, thus flooding the market with money supply. This has increased the velocity of money exchanging hands (economic activity) and has encouraged businesses to borrow more for growth projects. In fact, a large portion of the world today has negative interest rates i.e. you get paid to borrow. This is unprecedented and has created a proliferation in passive investment strategies as seen in the explosion in passive ETFs thus creating a mammoth asset bubble, not just in growth assets, but every single asset out there is in a bubble! You name it - tech, healthcare, real estate, gold - heck even bonds! If the denominator (or interest rates) is low, your asset price can be as high as you can imagine.

According to Bloomberg, in 2009, active funds had nearly three times more assets under management than passive. In 2019, for the first time, passive funds overtook active funds by market share, with more than $5 trillion invested in these low-fee vehicles. The very basis for active investments is to take away money from companies that destroy value and fund companies that add shareholder value. Active investing enabled better price discovery. With the advent of passive ETFs, a majority of the companies, good and bad, have gone up. Price discovery is destroyed as these strategies don't require security-level analysis. As a result, bad companies have not been penalized enough and good companies are overbought. These days, you often hear things like Stock XYZ is trading at 40x revenue and Stock ABC is trading at 100x earnings. It is silly! It is unprecedented, as folks don't talk enough about cash flow multiples. It is downright scary! Long story short, valuations are stretched and there are too many passive ETFs out there that own the very same companies!

Now What?

Given the pandemic, if there is an "outflow" or a panic-driven "liquidation", all the passive ETFs will try to exit through the same door. And that won't be pretty. This won't be a 2-sigma event, but it will be a 4-sigma event as this inefficiency will be instantly arbitraged out of the markets, creating a massive fat tail risk. The juice isn’t worth the squeeze. The passive ETF gold rush will end and the bubble will explode into oblivion.

Stay safe out there!