Supine Risk

We’re in New York this week while companies gather in Dallas for the annual NAREIT conference, the association for real estate investment trusts.

Real estate is about 3% of the S&P 500. By comparison, Technology is 23%, the largest by a wide margin over healthcare and financials (a combined 27%).  Yet large REIT Exchange Traded Funds hold more assets than big Tech ETFs, with the top ten for each managing $54 billion and $46 billion respectively.

The implication is disproportionate influence in real estate from passive investment. With market sentiment the weakest in more than a year by our measures, I’m prompted to reflect on something we’ve discussed before: Risk in passive investment.

One might suppose that investments following models are less risky than portfolios built by selecting stocks on fundamental factors. Singling out businesses leaves one open to wrong decisions while baskets diffuse risk. Right? Look at Vanguard’s success.

Yes. But missing in these assumptions is what happens when concentrated assets are bought and sold. The biggest real estate funds are mainly at Vanguard, Blackrock, State Street and Schwab. It’s probably true across the whole market.

Behind ETFs, stocks are concentrated too. We’ve described how the top thousand stocks are more than 90% of market volume, capitalization and analyst coverage. Just 8% of assets are in the Russell 2000, the bottom two tiers of the Russell 3000. And there are barely more than 3,300 companies in the Wilshire 5000 now.

Lesson: Everything is big. One reason may be that money buys without selling. Inflows are topping outflows (hint: That has now stopped for the first time in over a year), so indexes aren’t paying out capital gains, skewing returns, as Jason Zweig wrote in the Wall Street Journal Nov 10.

Mr. Zweig highlights the PNC S&P 500 Index Fund, which is distributing 22% of assets as a taxable gain because people have been selling it.  The fund has performed about a third of a percent behind peers. Add in capital gains and the sliver becomes a maw.

Mr. Zweig notes that some big funds including the Vanguard 500 Index and the State Street Institutional S&P 500 Index Fund haven’t paid out capital gains in more than 15 years. If investors aren’t cashing out, assets aren’t sold, capital gains aren’t generated, and results don’t reflect underlying tax liability.

To me there’s a bigger passive risk still. With more money chasing the goods than selling them, things perpetually rise, turning investor-relations professionals and investors alike into winners, but begging the question: What happens when it stops?

I’ve always liked Stein’s Law as a bellwether for reality. If something cannot last forever, said Herb Stein, father of famous son Ben, it will stop. Since it cannot be true that there will always be buyers without sellers, the prudent should size up what happens when giant, concentrated owners shift from buying to selling.

To whom do they sell?

And how can we have buyers without sellers?  Mr. Zweig talks about that too, indirectly. We’ve written directly about it (and I’ve discussed it with Mr. Zweig).  Indexes and ETFs may substitute actual shareholdings with something else, like derivatives. If you can’t find an asset to buy, you buy a right to the asset. This idea torpedoed the mortgage market. You’d think we’d learn.

There’s a rich irony to me in equities now.  During the financial crisis, regulators bemoaned the long and risky shadows cast by giant banks too big to fail because failure would flatten swaths of the global economy.

That was just banks. Lenders.

What we’ve got now is the same thing in the equity market, but risk has transmitted to the assets we all depend on – not just the loans that leverage dependency.

It’s the most profound reason for future policymakers (Jay Powell and Steven Mnuchin) to avoid the mistakes made by the Bernanke Generation of central bankers, who depressed interest rates to zero out of frantic and preternatural fear of failure.

The absence of reasonable interest rates devalues money and pushes it into assets at such a profound rate that for very long stretches the only thing occurring is buying. Result: Everything is giant, and concentrated – the exact opposite of the way one diffuses risk.

When it stops there are no buyers left.

How to get out of a problem of this magnitude?  Quietly. If enough people tiptoe away, there will be buyers when everything is properly priced again.  The hard part is knowing when, because passive risk reposes supine.