How Passive Investing Amplifies Volatility (w/ Danielle DiMartino-Booth & Chris Cole)
DANIELLE DIMARTINO BOOTH: You talk about passive investing. It's a hot button. 90% of flows go into passive strategies. Even pensions are in passive strategies. Talk about the perfect-- perfect liquidity of passive investing. CHRISTOPHER COLE: The concept of passive-- and now, we are at a point where passive investments have eclipsed active for the first time in history. And my friend Mike Green who's a friend of "Real Vision" has a lot of fantastic research on this. DANIELLE DIMARTINO BOOTH: Yes, he has. CHRISTOPHER COLE: And I've done some work, in essence, trying to replicate his assumptions using some toy models and was able to do that. His theory, at the end of the day, is that at a certain point, if the market is dominated by passive actors, it not only amplifies volatility, which I completely agree with-- if there is no other incremental seller against a buyer or buyer against a seller, each incremental buy or sell will result in massive movement in the underlying. DANIELLE DIMARTINO BOOTH: It's an amplifier. CHRISTOPHER COLE: It's an amplifier. Because if you look at active investors, active investors are a volatility dampener. Value investors will come into the market, and they will buy when there is a big collapse in asset prices. So they will in essence put a floor underneath asset prices. And they'll sell when asset prices go to high. Well, you remove all the active investors, and that will amplify volatility. The other factor that comes into play a lot of the time is this idea that it actually reduces the alpha available to active participants. DANIELLE DIMARTINO BOOTH: Clearly. We're watching one asset manager after another, one hedge fund after another go away. CHRISTOPHER COLE: Because, in essence, passive is in its own right a systematic strategy. It has elements of-- it is a basic systematic strategy. So it goes back to the soul of investing. There are two different competing thought processes, I think, that are at war with one another. The one thought process is that assets should have a value, that there should be a value, and that market participants are fighting to determine what that value is. But there is, in theory, some intrinsic value to it. DANIELLE DIMARTINO BOOTH: Price discovery. CHRISTOPHER COLE: Price discovery. There is a second school, which I think is gaining strength right now, which is forget intrinsic value. All that matters according to this school of thinking is the price momentum of the asset. DANIELLE DIMARTINO BOOTH: You can burn your MBA. You don't need it anymore. CHRISTOPHER COLE: That's right. So aspects of factor investing follow this principle, whether it's momentum, quality, whether it's FANG, or whether it's ownership of company management. Whatever the factor is, as long as people believe in the factor, and keep buying, and keep providing-- as long there continues to be liquidity, that creates value. I'm clearly in camp number one. I clearly believe that there's intrinsic value. I believe-- DANIELLE DIMARTINO BOOTH: Well, if you go back 100 years, there is. CHRISTOPHER COLE: There is. And I would like to quote Harley Bassman, who once had a fantastic quote. He always says this, that pigs can fly if shot out of a large enough cannon. They always return to earth as bacon. He's so right on the money with his usual wit. With a large enough amount of central bank stimulus and enough ability to create debt, you can create this illusion as to momentum in these factors that-- so I actually think passive investing is actually just a liquidity momentum trading. DANIELLE DIMARTINO BOOTH: I would agree with you. Look-- well, October 2018, it was not pretty. It acted as an amplifier, but on the downside. But we haven't seen a lot of that.