The World Turned Upside Down

Strange things did happen here
No stranger would it be
If we met at midnight
In the hanging tree.

– Lyrics from the theme song of The Hunger Games

If buttercups buzz’d after the bee,
If boats were on land, churches on sea,
If ponies rode men and if grass ate the cows,
And cats should be chased into holes by the mouse,
If the mamas sold their babies
To the gypsies for half a crown;
If summer were spring and the other way round,
Then all the world would be upside down.

– Lyrics from a 17th-century English folk song entitled “The World Turned Upside Down”

A bull market is like sex. It feels best just before it ends.

– Warren Buffett

Longtime readers know that I read a wide range of newsletters, articles, and websites every day. There are times when I see patterns in the information flow that are like puzzle pieces begging to be put together. I have been struck in the past few days by the amount of analysis and number of data sets that are all pointing to the same conclusion: There is a bull market in complacency.

Strange things are happening out there. One formerly successful billionaire hedge fund manager after another throws in the towel, sending the money in their funds back to the clients, confessing that they don’t know how to handle these markets. I am reminded of the surrender of Cornwallis to Washington at Yorktown in 1781. Tradition has it that, as the British surrendered, their band played the old English folk tune “The World Turned Upside Down.”

The inability of so many active funds to find that “edge” that formerly allowed them to produce alpha is quite remarkable. I have written about this phenomenon before, so I won’t go into detail here; but it is the massive move from active to passive funds that is the core of the problem. Passive investing simply allocates among a number of index funds that indiscriminately buy or sell the stocks that are in their indexes.

That means if you buy an index fund for the Russell 2000 (small-cap stocks), not only are you getting the stocks of well-run companies, you are also buying the 30% of the small-caps that have less than zero earnings. And since we’re seeing literally hundreds of billions of dollars moving to passive investing and away from active managers every year, that is a lot of indiscriminate buying. Barron’s estimates that passive investments could make up half of all US equity retail flows in 2018 and 2019, and this calendar year will see the largest ever dollar shift in assets under management from active to passive. Part of the reason is a general move to lower fees, and part is simply that active management has failed to outperform.

Here’s the problem: It is extremely difficult for an active manager to buy the best companies and/or short the worst companies and show much outperformance relative to the passive index funds. No matter how much research you do, no matter how well you know those companies, your research is not giving you an edge over the massive movement to passive investing.

And if you have no edge, you have no alpha. It is just that simple. Personally, I don’t think this is the end of active investing, but the game is going to have to change.