I haven’t written anything in a while but I’m still here, still doing what I’ve always done. This post will be about how I’ve actually adapted the management of client portfolios over the past handful of years to an ever-changing market environment. I think markets may potentially be in for an extended period of tough sledding, and if that’s the case, the usual approach to allocating portfolios could struggle a lot.
A quick side note first on why I haven’t been active on the blog the past few years: I wrote the blog as a way to communicate updates with clients that would also allow others to follow along as well. But I couldn’t get all of my clients to follow the blog so at some point a handful of years ago I started recording a monthly video update and directly emailing it to all clients. The information started to get pretty redundant so I simply transitioned to the videos as my preferred method of communication because they could contain more information and took less time. I may post big picture updates from time to time but don’t plan on being as active as I was a few years ago. Now, back to the show.
As an advisor, my job is not to buy stocks and just hope the market doesn’t go down. My job is to help my client build a financial plan, tailor their portfolio to their plan and then look out for and manage risks that could derail things.
On that note, I’ve observed a major change in the investment markets (primarily the stock market) over the last decade, and with it, have been continually adapting my approach to managing my client’s portfolios to remain as best aligned with how the market “flows” now in order to manage the new associated risks. These changes stem from:
- Algorithmic strategies dominating the daily volume in markets
- The amount of leverage being utilized in markets
- The amount of trend-following, momentum-oriented strategies that have garnered money
- The increased use of stock options and primarily index options (i.e. on the S&P 500 index) as a means of both short-term hedging (e.g. 0 or 1-day to expiration (0DTE) options) and volatility selling (selling options to collect Vol and time decay)
- The increased role of central banks managing liquidity conditions within the financial system
- And the mac-daddy of them all – the continual shift to index funds and ETFs.
All of these dynamics are making the stock market in particular more volatile in both directions. They build upon one another to create relentless squeezes to the upside as buying begets more buying, until everyone is on the same side of the boat and then a vicious unwind of leverage and positioning occurs in a very sharp drop, and then the process starts anew.
Most of the items listed above drive the day-to-day behavior of the stock market (that’s right, despite what CNBC may have you believe, it has absolutely nothing to do with news, earnings or fundamentals…) but it’s the last bullet point that is the most important to understand and is the one I’m most concerned about.
Mike Green of Simplify Asset Management has done numerous podcast interviews over the last few years highlighting the distortions being created in the markets from the relentless shift to passive index funds. This interview from June is a fantastic summary of what he has found over the years. I strongly recommend that you listen to it… and then listen to it a second time to pick up all of the little details you missed the first time. If you manage your own portfolio or are an advisor that manages other people’s money, it’s important to understand the water in which you’re swimming.
Mike Green on The Rational Reminder Podcast
This won’t do it justice, but here is the very high level overview:
Index funds are basically the world’s most basic algorithm with a rule set that says: if money comes into the fund today (net new deposits), buy all of the components of the index at their corresponding weight, and if money goes out, sell all components. But here’s the kicker – the purchases and sales must occur each day regardless of price/valuation! Vanguard can’t say “you know, these stocks look expensive right now so we’ll just wait a few days for a pullback…”
Additionally, once the purchases are made, those shares are effectively removed from the market until the fund receives outflows. It literally doesn’t matter how high a stock goes, how expensive the valuation might become or how much demand there is for it, Vanguard, Blackrock and all of the other index fund providers cannot decide to sell or offer to sell shares into the market unless they have redemptions (net selling) from the fund.
As money continues to move in the direction of passive index funds, more and more of the available float (shares outstanding and issued in the market) gets eaten up and is removed from the market. When you add in all of the “active” funds that are really just closet index funds and passively managed long-term pools of capital, like pensions, endowments, etc., you have a majority of the outstanding float of the stocks in an index that’s simply held and not available for sale on any given day. There’s no way to know the exact number but I would estimate that roughly 70% to 80% of the outstanding float of most stocks in the S&P 500 Index, especially the largest companies and ones that overlap in other indexes like the Nasdaq 100, is passively held off the market and not available for sale.
“So what?” you say. Well, the net effect this has on the price of these securities are the distortions we’re seeing. As more of the float is gobbled up, but a relentless flow of money continues to pour in, you have money chasing fewer and fewer available shares, which creates an almost relentless squeeze higher in what ultimately turns parabolic. This is what happens when demand meets inelastic supply. It’s a virtuous circle to the upside based solely on fund flow dynamics, not company fundamentals, stock valuations, or the like.
This dynamic really started to take hold about a decade ago when the Department of Labor changed a regulatory requirement for company retirement plans like 401(k)s that stated the default investment option for any employee that does not elect their own allocation is a target date retirement fund. And what are target date retirement funds?? A basket of index funds to create a total portfolio allocation. Millions of people now use these for the sake of simplicity in their retirement account and this ultimately creates a recurring monthly inflow of new dollars into index funds.
These flows and the amount of money invested in index funds have become so large that they are creating turning points and moving the stock market in big ways. For example, Vanguard rebalances their target date funds in the last 5 days of the quarter. Whenever we see stocks make a big move in a quarter, it triggers a rebalance large enough (i.e. shift money from bond index funds to stock index funds to increase their weight back up to target) to change the direction of the market. Below is a chart of the S&P 500 Index over the last 7 years. The green dotted lines highlight points where a large pullback in the stock market was essentially halted in the last week of the quarter once Vanguard began to rebalance. Almost every major pullback in the stock market over the last 7 years has ended in the last week of the quarter! Pure flow dynamics…
These flow dynamics are also why value stocks have been left for dead for the last 15 years and why tech stocks continue to outperform everything else. I’m not saying that many of these tech companies aren’t great companies or haven’t been growing; what I am saying is that the magnitude of their outperformance is arguably attributed to the fact that they’re the largest companies in the index and thus receive the most “flow” as money comes into an index fund. Given the shrinking supply of shares available, a leveraging effect has been created to the tune 7x or more – meaning $1 of buying increases the companies market cap $7 or more. So, for every $100 million of new money that is invested in an S&P 500 index fund, ~$7 million goes into Apple and inflates Apple’s market cap by ~$50 million. ~$6.5 million to Microsoft and inflates its market cap by about ~$45 million, and so on down the list to where $100 million of new inflows probably lifts the total market cap of the S&P 500 index by anywhere from $500 million to $1 billion. I believe this is a major contributor to why the stock market cap-to-GDP ratio continues to climb.
Every year active, value-oriented managers underperform the index, investors wonder why they’re paying higher fees for underperformance, and ultimately shift their money over to an index with low fees. This creates net selling pressure on all of the “undervalued” stocks so they never catch a bid to come up to an appropriate valuation, and net buying pressure for everything in an index basket, regardless of valuation. And the circle continues…
While this creates a virtuous circle on the way up, it also creates a dynamic of a vicious circle on the way down, once again adding to the increased volatility of directional moves in the stock market. So, what could flip this dynamic and lead to outflows from index funds?
A few things come to mind, like:
- Baby Boomers shifting to a more conservative allocation within their portfolio = less stocks
- RMD’s leading to selling from index funds in their portfolio
- A rise in unemployment leading to less retirement plan contributions and thus less index fund inflows
- Any event that spooks investors enough to de-risk
We recently crossed the tipping point where more than 50% of all investment dollars are invested in index funds. Let that sink in… And some really great research from people way smarter than me shows that weirds things will start to happen as we cross this 50% threshold and continue to shift in the direction of indexation. It will continue to increase the volatility of the stock market as the supply of available shares shrinks thus making the market more inelastic. Inelastic markets make for parabolic moves when supply can’t match demand.
Let’s take this to the extreme and say that 90% of all money in stocks is invested in index funds. Something happens and roughly 10% of that money wants to derisk and rotate out of stocks. Who’s left to buy those shares that the index funds have to sell? Remember, those redemptions need to be met and the fund will transact at any price, regardless of valuation. What would the ultimate clearing price be? What is the true value of these shares? How high has this reflexive flow dynamic taken stocks above their “true” value? If only we knew those answers…
What would happen is that an air pocket would be created and the clearing price would be substantially lower than the previous days closing price. We would hit the daily circuit breakers to halt the market and the index funds would be not be able to transact to make the sales and ultimately would not be able to meet the redemption request. This is the structural flaw that has been building in the markets for years now as more money continues to shift toward index funds and it’s likely to create some big problems in the future.
I’ve been thinking about this a lot over the last few years and, in particular, thinking about how to appropriately approach the markets for my clients given these dynamics. The tricky part is that you’re basically forced to play the game, meaning the large majority of active managers will continue to underperform the index so long as inflows to indexes continue, and thus you have to own the index. And by participating, you’re just adding to the problem and exposing yourself to the vicious unwind should it start to occur.
I’ll get to my solution a little bit later. First, let’s entertain another scenario. What if these index flow dynamics never really lead to a major problem? Or maybe it’s 25 years down the road and not really something to worry about today. The other issues of algorithmic strategies, leverage, options and the like still exist. Not to mention that the S&P 500 index in particular is dominated by big tech companies today. In short, the index itself is much more of a “growth” index and these tend to be more volatile in nature and exhibit larger downside risk during downturns. While a sharp unwind purely caused by index outflows may not occur in the next few years, other risks still exist that could trigger some nasty bear markets. After all, bear markets have always occurred and will continue to happen. Markets are cyclical.
The scenario I’m probably most concerned about today is the potential for another “lost decade” of stock market performance. Historically, stocks tend to move in long secular cycles that can last anywhere from 10 to 20 years. It’s not uncommon to see a 20 year bull market followed by 10 to 12 years of a secular bear market. US stocks have been on a great run since 2009 but there are structural macroeconomic factors building that make me concerned about the possibility of another secular bear market on the horizon.
The biggest killer of financial assets (i.e. stocks and bonds) is inflation. Everybody remember 2022?? Inflation always leads to nasty bear markets, and we have a structural backdrop today, given the size of the deficits the government continues to run, with no end in sight given entitlement liability projections and the size of the debt load adding interest, I see no way for the expansion of money to end. The Fed will also be forced to continually step in and monetize the government bond market for the sake of “market stability.” If we have actually shifted into a period of structurally higher inflation, which I believe we have and certain aspects of the investment markets are also saying that we have, this could be quite problematic for traditional asset classes like stocks and bonds as well as any standard buy-and-hold portfolio allocation models that are stock/bond heavy (I’m looking at you target date retirement funds!). This is what made the 1970’s such a difficult investment environment.
Below are some long-term charts of the S&P 500 Index. The top chart shows the index in nominal prices (the price you see quoted) and the bottom chart is adjusted for inflation (i.e. real returns). The last two secular bear markets were 1968-1982 and 2000-2010 (red boxes), where the S&P 500 returned 0% and -21%, respectively. In real terms though, it returned -51% and -38%, respectively. Not in a year; that was the total return over more than a decade – ouch! Both of these secular bear markets occurred during periods of higher inflation, whereas most secular bull markets occur during periods of falling inflation. This is also why commodity prices tend to be inversely correlated to stocks and real assets tend to perform best during these secular bear markets. Note the long cyclical wave-like behavior in the bottom chart.
If structural dynamics are forcing me to play the game by owning the index, but the game might not end well given the macro backdrop and risks being embedded in our markets today, then I’m going to play it by my rules. This is vitally important for my clients and anyone else that is retirement oriented, as in coming up on retirement, currently retired, etc. – basically, anyone that is close to or currently taking withdrawals from their portfolio. Because once you enter the distribution phase for a portfolio, how you manage a portfolio changes. Reducing downside risk becomes priority number one because of the issues it can create while taking withdrawals. Not to mention the simple risk that a “lost decade” could create. If you retire today on the assumption that your portfolio will earn an average rate of return close to historical averages but we then go through an extended period of below average returns, that could destroy your entire retirement plan. Averages are all well and fine if you’re not taking withdrawals, or you’re adding to your portfolio while working, but something called sequence of returns risk is huge once withdrawals begin.
For years now, I’ve been building and utilizing systematic tactical allocation strategies for my clients. Put simply, it’s a set of rules that tells you when to be in an asset class, when to be out, when to flip from one to another, etc. This is in contrast to the traditional standard allocation models which simply hold a diversified portfolio of asset classes through every environment, including bear markets. There are a few reasons for doing it this way, including:
- The strategies are designed with a primary focus on managing/reducing downside risk. When the stock market begins to drop, there’s no way to know if it’s just a minor 5% pullback or the start of nasty down 50% bear market. Following a set of rules takes the guesswork, indecision and potential of making an emotionally driven mistake out of the equation.
- When you utilize a systematic approach, you can take your rules and backtest the strategy. The point of doing this is not to optimize for the past but it’s to see how the strategies perform in different market environments. For example, how did it perform in periods of high inflation versus low inflation, a booming economy versus a severe recession. We do not know what the future holds so we want to make sure we’re incorporating strategies in a manner to build resiliency no matter what the environment is. That’s how you make a bulletproof retirement plan.
- Most retirement oriented investors have no desire to experience a large drawdown in their portfolio even if they can technically afford it. I have numerous clients that have said to me “I don’t ever want to experience a year like 2008 ever again.” Standard asset allocation models do not manage downside risk and have historically taken 20% to 30% hits during some of the big bear markets, including 2022 and 2008. I’ve grown increasingly convinced over the last few years that taking a systematic, tactical approach to one’s stock market exposure is the right course of action and increasingly needed the more risk averse someone is and the higher the annual withdrawal needs.
So, what are the issues with utilizing an approach like this? Just about the only major one that I can think of is tax efficiency. The more active you are, the less tax efficient you are, so I generally try to run these strategies in tax deferred retirement accounts like IRA’s, Roth IRA’s, etc. For taxable accounts, you can hold other assets or parts of the portfolio that are more tax efficient or, you can wrap these strategies in the wonderfully advantageous tax efficiency of an ETF to avoid realizing capital gains as the strategy adjusts its allocation, and that’s what I’m looking to do. You see, an ETF, when managed properly, doesn’t buy and sell securities internally, it’s transfers them, so no capital gains are realized, and thus no gains distributed to shareholders, allowing for a continual compounding of value in a tax efficient manner.
Last year I did an extensive research project where I took some of these systematic strategies that I’ve built over the years and I thought “hypothetically, if I wanted to expand this to an entire portfolio model how would I do that? How would I approach all of the asset classes and the construction of an entire portfolio from a purely systematic approach?” I was absolutely thrilled with the results and was able to put together a “core” portfolio model that manages downside risk better than anything I’ve seen out there. I believe so strongly in the value of these strategies and this portfolio model that I’m looking to start an exchange traded fund (an ETF) to run this portfolio model in. By doing so, it will provide a significantly more tax efficient solution for my clients as well as give access to these strategies (in a tax efficient manner) to other investors who are not currently clients of mine.
I’m writing this post to gauge interest. Please reach out and let me know if you see the value in this portfolio model and would invest in a fund like this if it were easily available to buy as an ETF.
I wrote a white paper on the portfolio model to detail the back story, the thought process of how I came to it and the results to illustrate why I believe it’s superior to standard buy-and-hold types of investing – especially for people taking withdrawals from a portfolio or desiring exposure to the growth potential of the stock market but wanting to limit the downside risk. I encourage you to read the white paper in its entirety and when you get to the very last page (Exhibit A, which lists the returns of the portfolio model backtest by year), please note the performance through the last two secular bear markets of the 1970’s and 2000’s. Because it is designed to manage downside risk, the portfolio model excels during the periods of highest risk. Anyone can make money in a bull market. Proper portfolio management is about managing risk so you keep those gains through the inevitable rough periods.
Please send me a message if you would like me to send you the white paper.
Thanks for reading and please let me know if you’re interested or have questions!
Cheers,
Nick