Smart investors are neither bulls nor bears, rather are pragmatists who are always looking to insure against the next crisis. They get nervous if things are going too well. One potential crisis that may been looming is one of the most crowed trades currently in the market – passive equity index investment.

Since the global financial crisis there has been a massive flow of investment into passive funds (a cumulative $1.6 trillion) accompanied by a significant outflow from active funds (outflows of around $400 billion).

Instead of looking for investment opportunities to beat the market, investors are opting to invest passively and in the process, are increasing their vulnerability to a large scale equity market correction.

Investors may see passive investing as reducing their investment risk or costs; however passive investment applies no consideration to the underlying company fundamentals or the liquidity of their investments. As the market diverges from the fundamentals passive investors continue to invest – it does not matter if the market is 10x, 15x, or 20x earnings, they just continue to blindly buy the market and take on more and more valuation risk.

There will be an eventual reckoning when the increasing valuations meet the harsh economic realities of the underlying company fundamentals. When something triggers the index to correct, fear will dominate and investors will seek the safety of cash in preference to equities. That point is obvious; over history such corrections have occurred frequently and the herd mentality of markets never changes.

As we saw during the global financial crisis market corrections are typically accompanied by a drying up of liquidity. Liquidity tends to be forgotten about in rising markets because it is plentiful, but when it is actually needed it is expensive to obtain.  Given their size passive managers in need of liquidity to fund redemptions may find it hard to locate potential trading partners to sell their equity holdings. They cannot sell to other passive managers as the funds all invest in the same underlying – the index. Limited market participation from active investors would exacerbate the liquidity problem.

Thus passive managers would be forced to sell their assets at progressively lower prices in order to generate liquidity creating a positive feedback loop, which amplifies its effect resulting in a significant market adjustment.

The scale of the crowding into passive equity products has the potential to increase the magnitude and duration of a future market correction. It would not take much for a series of orderly redemptions to tip into a rout as investors stampeded for the exit in a bid to reduce their exposure to equities. And on it goes: as investors redeem their holdings, passive funds selling further equities to fund redemptions putting further downward pressure on prices. This in turn produces more investor redemptions as they want to reduce their exposure to falling equity markets. Ouch!

It is very difficult to hedge the risks described above. In the event of a market correction correlations amongst asset tend to move towards one, and all asset classes typically to go in one direction – down.

There is no certainty that this will eventuate however being forewarned is being forearmed. Market neutral, unlisted, absolute returns, active funds and derivatives all have a role to play in reducing this risk in investors’ portfolios due to their lower correlations to traditional asset classes.

Giving away some of the upside to add a little bit of lower correlated asset classes to a portfolio or using derivatives as a portfolio insurance policy is a small price to pay to sleep easy during the eventual correction.

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