This May Be the Biggest (and Most Overlooked) Market Risk Right Now

The biggest risk to the market right now isn’t fundamental – it’s technical. Not technical as in chart analysis (e.g. "The technicals look bad), but rather the structural nature of the U.S. equity market.

This May Be the Biggest (and Most Overlooked) Market Risk Right Now - 56

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Specifically, one of the least discussed risks to the U.S. equity market is the $2.6 trillion in assets under management (AUM) in the ETF industry, which is now more-or-less tied with the AUM of the entire hedge fund industry. The proliferation of passive investing has accelerated demonstrably in recent years amid the confluence of three key factors:


  1. The secular trend of underperformance among active managers
  2. A trend of minimal variance in returns at the sector and style factor levels
  3. A trend of subdued volatility at the index level

ETFs provide their investors – which are increasingly institutional – a cheap way to passively allocate to systematic risk. That’s great for investors, but in doing so, it severely disrupts market functionality (e.g. all-time lows volume and turnover) and distorts the price discovery mechanisms at the security level (e.g. tight, but spurious correlations in “risk on” or “risk off” episodes).


This May Be the Biggest (and Most Overlooked) Market Risk Right Now - Russell 3000 Turnover


When the market goes up, no one cares. But when investors panic – as previewed in early-to-mid October – the market goes down hard and fast because investors are likely de-risking their portfolios of entire factor exposures (e.g. “U.S. equity risk”), rather than of individual names.


In summary, the proliferation of passive exposure to market beta likely means the buying power of investors who are prepared to defend individual names/stories is getting dwarfed, at the margins, by the selling power of those that will just want out when the tide turns.


It took nearly 74 weeks for the U.S. equity market to trough during the last major downturn (10/9/07 – 3/9/09). If the October 2014 draw-down was any indication of the current dire state of market pricing dynamics, a similar decline is likely to have substantially more velocity absent outright central bank intervention.


“Velocity” * “Volatility” = “Mass Panic”, whereby “Mass Panic” heightens the risk that investors make decisions that lead to permanent or semi-permanent capital impairment.


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