It is ironic……Equity market assets are increasingly becoming passive while at the same time equity market trading is becoming more algorithmic.
According to the Investment Company Institute (ICI) who tracks such data, index equity investments have grown to be 35% of equity fund assets and 13% of total US stock market capitalization as of the end of 2017. To the extent that there have been any fund flows into equities since the Financial Crisis, they have been almost entirely into index-based investments. Actively managed funds are only 16% of total US stock market capitalization. The bulk (71%) rests in the separate accounts of insurance companies, pensions, individuals, and others. Who knows how much of that exposure is also tracking some broad-market benchmark?
Meanwhile, we have seen reports from several sources suggesting that between 50% and 70% of daily stock trading volume is driven by computer algorithms. Most of that is of the “high frequency” variety which places trades by the nanosecond seeking to profit from the next price tick. JP Morgan estimated that perhaps only 10% of US equity trading is by fundamental investors who are making choices of what companies to own based upon corporate performance and valuation.
With so much “un-thinking” in the equity market, traders are quick to read into market volatility to infer what it “thinks” about this or that. In fact, most high frequency trading programs impacting stock prices tend to be momentum-driven. That is to say that they pile trades into whatever direction the price is moving trying to ride-along, both up and down. It is not a leap of logic to say that high turnover trading strategies pushing prices further in whatever direction they happen to be going combined with the mass of equity assets indifferent to valuations or fundamentals exacerbates volatility, rendering it far less informative than it might once have been under a different market structure.
We are fans of index-based investing and incorporate it into portfolios where appropriate. We are not fans of “passively” riding along unthinking of the risk. We believe even portfolios implemented entirely of index funds require thoughtful construction to develop the appropriate asset mix to meet a financial goal (across asset classes, geographies, capitalization, and styles), selection amongst the thousands of index funds available today (and changing), and how/when to rebalance the portfolio as market conditions and circumstances evolve. There is no irony, in our opinion, in actively monitoring a long-term oriented index portfolio.
Often, the right answer is to make no change – but do so thoughtfully.