The real reason for the recent market turmoil

Markets have undertaken a remarkable round-trip over the past three weeks, leaving many investors back precisely where they started. Had they done what we all should (but usually don’t) and avoided looking at a screen during their summer holiday, they might be forgiven for thinking nothing had happened this month.

The blink-and-you-missed-it correction has been explained in several ways, none of which holds much water. It seems a stretch, for example, that investors should have decided at the beginning of August that recession was imminent only to refocus a week later on the soft-landing narrative that they’d just dismissed. Or that they should have written off the AI story only to dramatically re-embrace it again. It’s unlikely that the Japanese should suddenly have regained their appetite for a carry trade within days of concluding that it no longer stacked up.

We need to look beyond these easy explanations, or the ‘thin summer trading’ stand-by, to understand the market’s heightened volatility this summer. Something else is behind the market’s gyrations that saw the Vix index - Wall Street’s fear gauge - spike from 10 to 60 and back again in a handful of trading sessions. And I think a good starting point might be the increasing dominance of value-agnostic passive investing, which some fear is making markets simultaneously less efficient and more fragile.

There is good reason to think that the rapid growth of index tracking mutual funds and ETFs makes markets less efficient. To understand why, think of two imaginary worlds. In the first, every investor is an active manager, acting on their judgement of the underlying value of the companies they invest in, buying or selling accordingly. In this world, markets are completely efficient - prices incorporate every piece of relevant information. This was the world that existed before the advent of passive investing, that initially seemed to provide investors with a ‘free ride’ on other investors’ research but which now risks eating its own tail.

Now imagine a parallel universe in which everyone has jumped on that free ride. The whole market is now passively managed, and nobody is doing any fundamental research at all. In this world, there is nothing to stop share prices diverging from fair value. All trading is ‘information-less’, driven simply by fund flows and market weightings. This totally inefficient market is as unsustainable as the totally efficient market, because in this ‘blind’ investing world, even a tiny amount of fundamental research provides enough of an edge to justify the cost of doing it. Too much passive investing would create the conditions for a return of active management.

Where we stand today is somewhere in the middle of these extremes. Depending on where you get your data, between a third and half of equity assets under management are now passive. But that is already enough to have a meaningful impact on the way in which share price ‘discovery’ takes place and the speed and effectiveness with which new information is incorporated. Markets are being distorted by the scale of passive investing - the prominence of the Magnificent Seven is the clearest example of this - but they are still functioning.

In the context of the recent ups and downs, what’s more interesting than this creeping inefficiency is whether the growth in passive investing is also making markets more volatile than they used to be. Writing on the recent stock market environment in the interim report of FTSE 100-listed investment trust Pershing Square, investor Bill Ackman was in no doubt where to point the finger.

Because so much of the market value of companies is now in the hands of permanent value-indifferent owners, he said, the importance of other short-term, often highly leveraged investors in setting the market price is magnified. But there’s more to it than this. Their heavily geared, in-and-out investment strategies also have no tolerance for even temporary losses. At the first sign of sentiment moving against them, they are therefore out, exacerbating price falls and ramping up volatility as the majority, passive holders are forced to follow suit to maintain their weightings.

The pendulum swing of markets is intensified further by the way in which money flows, both in and out of an index fund, create buy or sell orders for all stocks in the index at the same time. All shares, therefore, move in the same direction at the same time. The benefits of diversification are reduced and systemic market risk increases.

Does this matter? On the one hand, the growing importance of passive funds and the mispricing it naturally creates is good news for an active stock picker. It provides the investment opportunities that a truly efficient market could never do. To take two high profile examples from the recent market turbulence, Apple and Nvidia were, at their low points, 17% and 31% below their most recent peaks. Many investors saw that as a compelling opportunity and Nvidia round-tripped from $135 to $99 and back to $130 in a month. It was the ‘fat pitch’ that Warren Buffett entreats us to wait for. Please note past performance is not a reliable indicator of future returns.

The market inefficiencies and volatility that the rise in passive investing is creating are the investor’s friends. To exploit them, however, we need to do two things. First, we need to invest according to real world financial principles and not just market valuation ones. If a tidal wave of passive money is making markets both less efficient and more volatile, we risk being drowned in our puny attempts to swim against the current. We need to see through the confused messages in the market price and try to identify the fundamental value hiding behind the static. And trust that it will emerge in due course.

Which points to the second key characteristic of a successful investment approach in today’s skewed markets. The last few weeks showed that, in the short term, fundamentals can tell us nothing about where markets are headed. But over a long enough time-horizon, the distortions created by the dominance of passive investing will be ironed out. It has always been necessary to adopt a long-term approach to equity investing; but in less efficient and more volatile markets it is essential.

This article was originally published in The Telegraph.

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