Alternatives Could Capitalize on Passive Equity Risk

As featured in Investment Advisor magazine’s September issue

Over the past decade, one of the most undeniable investment trends has been the move toward passive equity products. The lower fees associated with index funds and a pretty good track record against active strategies in the most efficient markets has led many advisers to build their clients’ portfolios with passive equity strategies. But passive products’ success could be financial markets’ next undoing.

Passive products now comprise more than 50% of all U.S. large-cap equity investable assets, a critical mass that has created distortions within equity markets. Long/short equity funds may be uniquely positioned to capitalize when those distortions reverse.

Before looking at how advisers should position themselves against the risks from the passive equity product proliferation, however, it’s important to understand how disoriented markets have become.

As more money has flowed into passive equity products it has disproportionately benefited certain factors, while pushing others extremely out of favor. A good example is the underperformance of the size factor. (When the size factor outperforms, it means smaller-cap stocks outperform larger ones).

When assets pour into ETFs or passive equity funds replicating an index such as the S&P 500, more money is allocated toward the largest names in the index. This has helped performance of mega-cap stocks and made the size factor out of favor.

For perspective on how this dynamic has played out, the valuation gap between the quintile1 of the largest stocks in the Russell 1000 and the quintile of the smallest stocks is at its widest since the unwinding of the internet bubble in 2000 and 2001. In other words, excessive flows into the largest stocks have pushed up their valuations while smaller stocks were left behind.

Factor distortions aren’t limited to size. The passive push has also led to extreme underperformance of the value factor, which by some measures is trading at its biggest discount since at least 2001.2 In short, an influx of capital into passive equity strategies has driven stock correlations higher. As stocks trade less on company specific fundamentals, it has created less potential for value stock price reversion when a company’s fundamentals improve.

The Passive Buildup Could Have Dangerous Consequences When Stocks Sell Off

The market distortions stemming from the recent passive push have set equities up for a new set of risks and dislocations when these trends unwind. The longest bull market in history can’t go on forever. When a volatility event strikes and money flows out of equities, much of it will come from all the flows that recently poured into passive equity products.

As that happens, factor trends will reverse themselves. For example, money flowing out of index-based products will likely adversely affect the largest stocks in the index. The size factor will outperform as smaller stocks do better.

Active managers in traditional asset classes such as equity have said they can take advantage of passive outflows in down markets, snatching up favored stocks as they trade lower. But alternative strategies, and specifically long/short equity strategies, may be best positioned to capitalize on the distortions passive flows have created.

Long/short funds are best known for taking both long and short positions in stocks. Historically, this has helped such strategies perform relatively well when markets sell off because the gains from the short positions offset losses in the long positions.

Lesser known is the fact that many long/short funds decide what stocks to go long or short based on what factors they believe are likely to out- or under-perform. Some of these funds even dynamically adjust what factors to short or go long based on the market environment.

Advisers will need to conduct due diligence on how a manager dynamically adjusts their factor positioning – and it goes without saying that the long/short manager needs to be correct on their factor calls – but long/short funds could find themselves in a unique position to benefit when the disorienting factor trends from passive equity investing reverse.

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