Will Passive Investing Cause an Avalanche?

I read an article about passive investing over taking 60% of the market, and an additional 20% being traded by robots. Nobody knows what this means. It’s a brand new phenomenon. The market index funds are up 39B while the active funds are bleeding to death down 90B.

Index funds are not index funds. They are index tracking funds. Total Stock Market does not hold all the stocks in the market. Last time I looked it held 180 stocks which are weight adjusted to track the market. I’m not sure what it holds today. Passive investing is built on the idea you buy and hold, and sell a little dab once in a while to buy hamburgers, or live off the dividends or some combo of that. Passive funds are owned by relatively inexperienced investors who bought in a time of sustained growth out of proportion to the norm. Market averages are thought to be 90% higher than the trends predict, so people are used to the good life. It is absolutely unclear what would happen if the market crashed. Would people violate “Buy and Hold”?

In addition the funds are not the index but a small fraction of the index, adjusted. When the sell orders come funds are selling those few stocks in the tracking fund, not the index which will accelerate the volatility in those particular shares and distort the funds price compared to the actual index likely a distortion to the downside. If suddenly your VTI is trading below par what you gonna do? The market will regress to the mean at some point, we can only hope the regression is orderly and covered by rational sustained growth and not all at once.

The robots follow trends and are algorithms tuned to maximize profit. As trend followers they will go long OR short. It’s buy low sell high OR Sell high buy low, that’s how they make money and they are agnostic to which pair of profit makers to employ. So in the up trend they are your ally tending to add to up momentum, but in the down your enemy if your a buy and hold type since their position becomes anti-momentum to your position. Shorting the market increases volatility and 20% is a pretty big short compared to 60% buy and hold. In addition the regular speculative traders will tend to follow the trend aka don’t fight the tape, so suddenly 40% of the market is aligned against you, where as 40% prior was aligned with you.

I read several Bogel books and articles and he was worried about this when indexing was only 20% of the market. If someone as smart and plugged in as Jack was worried who am I to blow that off?

What to do, what to do? First off consider your risk profile. A 80/20 has lot more to loose in this kind of crash than a 50/50. Don’t presume “it will come back” as that is unclear to me. The market is already something like 90% over valued. If 60% get burned it’s very unclear 60% will return, and I think many will cut and run at any price adding to the volatility.

Own stuff less likely to sell. I own DFA funds through an adviser. You can only own those through an adviser, and a good adviser can stand in the way of your panic. The best antidote for volatility is owning the VIX unfortunately nobody can afford the VIX but professionals, long term because of the carry charges and the ETF are not a good stand in. The don’t really track the VIX very well. Own some GLD. GLD’s volatility tends to be in the opposite direction from stocks in a crash so the net is a reduction in volatility. Own some cash equivalent like a tangent portfolio. The tangent is mostly bonds so it’s volatility in a crash is very low and it gives you something to spend while waiting for the dust to settle. It’s like a security blanket.

One thing to remember is owning stocks is owning property. They are NOT cash. The more property you own the richer you are, so it’s a good time to buy some property when it’s on sale if you can stomach it. It’s also time to tax loss harvest, a different way to make hay while the sun shines. To tax loss harvest you need brokerage stocks so a brokerage account would be a good thing to own. May take a while to pay off but it’s always done so in the past.

That 60% passive index + 20% robots freaks me out.

6 Replies to “Will Passive Investing Cause an Avalanche?”

    1. The way to check is look up S&P 500 in yahoo charts then add iau and then gld as far as I can tell they track identically. when I do an efficient frontier plot on both IAU wins 100% GLD predates IAU by several months and got off to a little rockier start. Not sure which is more expensive to own

  1. It is a shame that the VIX is not availalbe to the masses as it would be a nice hedge to have as a component of your portfolio.

    I agree that there is going to be some interesting changes in the future as index funds continue to grow in popularity. This can certainly lead to a tipping point where negative consequences can become more prominent.

    1. Hey Xray I think we are already there. My impression is the passive market of this kind is a kind of macro reactive mass and works like chemistry. If you remember thermodynamics there were state functions which described variables of internal energy, enthalpy (extermal energy) and entropy which is a change in order. Those variables came together in an differential equation called the Gibbs free energy equation and was written

      dG = dH – Tds

      This equation described the state of a system. If dG became negative energy was released due to chemical reaction heat was released to the atmosphere and a new state of equilibrium between reactants and products existed, thus

      2H2 + O2 -> H2O + heat

      and the loss of heat forces the reaction to the right and keeps the new H2O as H2O and does not readily reconvert to O2 and H2 without a ton of added heat. The reaction has an energy barrier that separates reactants and products, and the barrier is why there is no O2 and everything is not water. The T in the equation is Temp and its the kicker if T gets big enough -Tds gets big and overwhelms Dh and dG goes negative and all hell breaks loose. Along the way there are partial high energy products like peroxides but those eventually resolve to stable water. On a big scale there is something called the law of mass action. So you may have O2 and H2 and nothing happens until it gets hot enough. Maybe 1 or 2 molecules of H2O are formed but not a big enough temp rise to pull the trigger. Once the trigger gets pulled it’s a different story.

      I see a 60% passive investing public with 20% robots and trend following humans and a market 90% above the mean to be this situation. 60% is a large mass of traders and you may “think” you won’t sell, but the human brain is wired for risk avoidance and that has a 4:1 control over behavior meaning if the unrisk position is exactly the wrong response the human will choose the wrong response 4 x out of 5. You have a bunch of inexperienced traders who are quite used to reward and buying the dips, what is going to be the response once an intolerable risk level is reached? GIBBS FREE ENERGY and it neurologically wired in at a level that is sub-cortical so it will happen PERIOD and the FED isn’t going to be able to stop it. It’s a neurological mechanism designed to keep you from being bitten by a snake and is very powerful and reacts without thought or rational input, and in fact requires immense rational input to over come the behavior, think jumping out of a perfectly good airplane for the first time on your own not as a harnessed pair. I did that in 1971 and the experience was not trivial. Back in those days we just used army chutes were were virtually guaranteed to open, you were hooked to a static line which would open for you and you were on your own. The only thing you had to do was convince yourself to take the first step.

      So that’s what I see as a likelihood based on neurobiology. Yes with a VIX hedge you could actually make money in a downturn.

  2. Robos are an interesting growing factor in creating/contributing to those sudden large shifts. Cousin who works for a hedge fund was making this same point to me several months back, and he had the institutional knowledge to bolster his fear.

    1. It’s sort of half way between a known unknown and a unknown. I did a study of the neurological (sub cortical) basis for risk. There is an extensive literature both in structural data and game theory data. Risk aversion dominates reward seeking 4:1, meaning there is a huge bias toward risk aversion and it’s sub cortical so not very amenable to rational input. It’s a non rational reactive evolutionary behavior aimed at self preservation and way predates human evolution. It turns out reward seeking can modify risk aversion. People normally would not go to a clip joint like Sandals but the constant barrage of the promise of sexy girls and free all you can drink wears at the risk aversion until one winter night you’re booking a flight. Casino’s are set up like this also, designed to modify risk aversion to separate you from your dough, so are grocery stores. God only knows you WANT the time of your life! FIRE actually has some of those elements as well. It’s easy, 4 x 25, you’ll be free, you’ll be independent, stick it to the man!, what could possibly go wrong? These things adjust down risk aversion to actual reward seeking as in the case of cocaine abuse or other drugs even pot which screw up the rational realistic assessment of risk. Clearly spending all your dough on cocaine or driving 3 miles per hour while stuffing twinkies in your pie hole is risky behavior.

      Since the FIRE crowd has their risk aversion modified, especially by “short term success” maybe 10 years of good returns, cracking the 1M level and feeling like a tycoon or master of the universe and some flimsy “side gig” income they forge forward with 100% STOCK portfolios wigglin their peckers about “return” and crowd funding and quitting work at 30. Then the market dumps and sub cortical risk aversion kicks back in. The coke doper when cracked suddenly is sorry. The Sandals guy feels remorse when he gets an $8000 credit card bill and realizes he never got laid and could have bought a truck load of booze for 8K. I think that’s the scenario we are facing, a bunch, way over leveraged with no experience of a down turn, primed and ready to sell out at the drop of a hat because their brains are hard wired that way. The robo’s and increased volatility will only magnify the fear to an unbearable level, that’s the way I see it happening anyway. Risk aversion is about hard wired self preservation and you will make completely irrational self destructive decisions just as treacherous as the decision to start using coke.

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