Back in October, JPMorgan Chase & Co. (NYSE: JPM) analysts Eduardo Lecubarri and Nishchay Dayal warned that the $7.4 trillion of global assets parked in passive funds could "exacerbate a rout" during the "next recession."
Well, they were half right: We're not in a recession.
But the escalating sell-off - especially in the highflying, index-leading big-cap stocks - is weighing heavily on passive investors.
"Weighing heavily," as in, passive investors are losing lots of money just about every day.
Active investors and traders, like us, have options. We can hedge, we can get short, trade puts, even go to cash - there are moves we can make.
Passive investors? Well, they could become active in a major way just about any day now. The panic would be legendary.
If that happens - and we are getting close to market levels that could turn passive investors into very active panic-sellers, a crash may not be far off.
The good news is, if you're ready for what could be coming, you stand to make a huge amount of money in a hurry...
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Passive Funds Are Like a Hanging Anvil
In their October report, Lecubarri and Nishchay said, "This is something worth noting at this late stage of a cycle given that passive investing seems to be trend following, with inflows pushing equities higher during bull markets, and outflows likely to magnify their fall during corrections."
The bank's analysis shows in 2007 money in passive funds amounted to about 26% of actively managed large- and all-cap funds' assets in the United States and 15% outside the U.S. "Eleven years later, those figures have jumped to 83% and 53%, respectively," according to the analysts.
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JPMorgan's report also notes that passive investing and passive investment funds are far "more skewed to large-caps than what their market caps would command, with passive assets under management in large-caps 10 times that of small- and mid-caps, making this asset class far more exposed to momentum selling during market downturns."
Look: We're not seeing outflows from passive funds just yet, but inflows slowed dramatically in 2018. What's more, those passive investors are, perhaps at this very minute, opening up their fourth quarter statements and seeing losses.
There are lots of those investors, with lots of cash in these funds...
The Passive Players Are Staggeringly Huge
According to The Wall Street Journal, assets under management (AUM) in U.S. equity index funds (index funds track benchmark and proprietary indexes and aren't actively managed) totals $4.6 trillion.
And 70% of those AUM are invested in broad market, mostly big-cap stock indexes modeled after the Vanguard 500 Index Fund, the granddaddy of index funds.
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Vanguard itself holds 51% of assets parked in passive funds in the United States.
The Vanguard Group with something like $5 trillion in AUM was founded by famed mutual fund innovator John C. "Jack" Bogle. His firm launched the first broad market index fund in 1975. As of 2018, it runs the Vanguard Total Stock Market Index (MUTF: VTSMX) - the largest mutual fund in the world, with more than $762 billion AUM - as well as the $441 billion Vanguard S&P 500 ETF (NYSEArca: VOO).
BlackRock Inc. (NYSE: BLK), the largest investment manager in the world, with more than $6 trillion in AUM, has a 21% share of assets in passive funds in the United States.
Rounding out the top three passive funds purveyors, who together control 81% of the market for index fund products, is State Street Global Advisors, owned by State Street Corp. (NYSE: STT). State Street has 9% of the index fund products market and more than $3 trillion in AUM.
While Vanguard is owned by the funds it manages and it in turn is owned by shareholders of the funds, BlackRock and State Street are publicly traded companies.
Both have seen their stock prices pummeled as inflows into their fund complexes slowed dramatically in 2018.
BlackRock, which traded at an all-time high of $594.52 in January 2018, traded as low as $360.70 a few trading sessions ago. It's down 39% in a year.
State Street saw an all-time high of $114.27 last January and traded down to $56.40 in December. That's a 49% pounding.
Now, passive investors are increasingly shifting assets out of mutual fund products and into exchange-traded products because exchange-traded funds (ETFs) can be traded all day, every day the markets are open.
For this reason, it's worthwhile to note the dramatic slowdown of ETF inflows from 2017 to 2018.
Here's Where Panic Could Lie in Wait
U.S. listed ETFs saw inflows totaling $476.1 billion in 2017, according to Morningstar.
In 2018, up to and through Nov. 30, inflows totaled $309 billion.
Final net flows for December haven't been published yet, but that's looking like a 35% decrease year over year - again, not including what might have flowed into funds during the worst December for stocks since 1931.
It doesn't take a rocket scientist to figure that with the Dow Jones Industrial Average (a big-cap index) trading on average just below 25,000 in 2018 and reaching an all-time high of 26,951 in October, passive investors who poured money into index funds in 2018 are underwater with the Dow currently at 23,393.
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Back-of-the-envelope math indicates that's about an 8.4% loss to date.
What happens if those passive investors see the Dow take out the new lows it made less than two weeks ago?
Will they panic? Will they become "active"?
What about the hundreds of billions of dollars that flowed into passive index funds in 2017 as the market was making new high after new high?
Those investors, if they were late to get on board the nine-year momentum train, got in sometime in 2017, when the Dow was around 22,000.
What happens to them if the Dow falls back there? Sure, the index rallied to around 23,400, but those gains aren't set in stone, and that's on mid-day Friday - it's not all that far of a fall for these volatile times.
Will they panic? Will they become active?
Maybe so... But the more important question is: How can we turn this potential mayhem to our advantage?
This Could Start the Mother of All Fire Sales - Be Ready
If spooked passive investors turn active in the event the Dow breaks important support at 22,000, there could be a trillion and a half dollars' worth of stock for sale in about a New York minute.
That selling would beget margin calls and more selling. And that's when the market could crash, and that's when I'd have my subscribers ready to make money on the way down.
I'm not saying we'll definitely get there or that passive investors will panic and turn active. There's always a chance they could average down and buy into any panic selling, like trying to catch a falling knife.
Unfortunately, I don't think passive investors are that well trained, that calm, that sure of the markets bouncing back if they're suddenly sitting on 25%-50% losses in their retirement and retail accounts.
Maybe I'm wrong.
If I'm not and there's a crash, it's going to be not just a buying opportunity, but the monster buying opportunity of a generation.
And that opportunity could pay off a lot faster than most folks realize. The market took five and a half years to get back to its old highs from the 2008 collapse.
If we get a crash this time, however low we go, it will take less than two and a half years for the market to double from its lows.
That's because there are fewer shares of stocks in the market today than there were in 2008, thanks to trillions of dollars in buybacks and mergers and acquisitions. Then there's the $11 trillion more in capital flowing around the globe today, courtesy of all that central bank printing.
With so much capital chasing so few stocks... shares could be bid right back up in no time, relatively speaking.
And if the market crashes, central banks will do what they have to do again, which worked out beautifully for equity investors the last time.
The most important thing is to be nimble and be ready to move if these passive investors wake up to a nightmare.
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About the Author
Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.
The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.
Shah founded a second hedge fund in 1999, which he ran until 2003.
Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.
Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.
Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.