Passive Investing Risks: Now Passive Investing Is Breaking the Bond Market

Now Passive Investing Is Breaking the Bond Market

Most of our content thus far has been focused on how passive investing has affected the functioning of the equity market. Hundreds of billions of dollars of annual inflows into index funds and ETFs exerts constant buying pressure on stocks that are members of major indices, like the S&P 500. These shares are locked away in the passive investing vault, never to  be seen again unless the indexing giants suffer outflows, something that has almost never occurred but is inevitable as passive investing becomes the dominant investment strategy used by almost everyone.

This month, Mike Green, portfolio manager at Simplify Funds, lays out a working theory of how passive is likely warping the bond market as well. Mike is well-known in the hedge fund industry, previously managed Peter Thiel’s personal investments, and has advised politicians and regulators on major policy matters.

In our view, he is the most vocal and intelligent thinker on how passive investing has destroyed markets’ price discovery mechanism.

Mr. Green, who goes by the handle @profplum99 on Twitter, publishes a Substack called Yes, I Give a Fig that has a modest $99 per year fee.

As shown in the post below from Jesse Felder, Mr. Green explains that the rigid systematic portfolio allocation models, such as the target date funds that dominate 401(k) accounts, are responsible for the recent moves between bonds and stocks that have gone against historical correlations.

As you can see from the chart in Mr. Felder’s post, the 30 year TIP yield has completely disconnected from the 5 year forward S&P 500 dividend yield.

So essentially, set rules in target date funds and other systematic passive portfolios dictate investors’ holdings between stocks and bonds. A person who is on the verge of retirement may hold the target date fund that is 60% stocks and 40% bonds, while a young individual just starting out in the workforce may have a target date fund that is 70% stocks and 30% bonds.

The key here is that the allocations are based strictly on the ages of the investors.

It does not matter if stocks have a price-to-earnings ratio of 100 and bonds have a yield of 20%, the funds would not sell stocks to buy bonds.

So, the fact that these target date funds are used in the the vast majority of 401(k) accounts and these allocation rules are followed widely elsewhere means that the natural mechanism for money to flow from stocks to bonds when rates rise is now broken.

A large and growing number of portfolios do not have that level of discretion. They just follow the model!

passive investing means don't think

Mr. Green provides further support for his view with academic studies from van Zundert and Driessen and Bretscher et al. He also shows how the total bond market capitalization of the USA is actually stable versus the global bond market capitalization, suggesting that the recent worries over record Treasury issuance and the spike in long bond yields are due to these flawed allocation models and not government deficits (which are admittedly very high) or inflation fears.

Yields are spiking because Treasury supply has increased but the typical increase in demand from investors attracted to higher yields has not materialized because so many portfolios are managed using allocation models.

This analysis suggests that bonds could be due for a violent buying spree if some of these allocation models are manually adjusted towards bonds and away from stocks.

We highly recommend reading Mr. Green’s Substack for more information on passive investing topics.

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