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Economy, Stocks, Trading  | December 26, 2019

If you have never witnessed the formation of a bait ball, it is a sight to be seen. To protect themselves against predators, thousands of fish come together and create a gigantic gyrating ball. It is majestic and at times seems to take on a life of its own. The idea is a simple one. Safety in numbers. Any deviation from the ball is asymmetrically penalized. This doesn’t guarantee survival, of course, but for a solo fish, remaining inside the ball is the best chance they have.

For predators, however, it is a feeding frenzy.

This, I would argue, is a good analogy to describe the opportunity facing active managers as larger swaths of the market are held by passive and quant-driven strategies. Even though the move away from individual stock selection and active management has been completely rational from the perspective of individual investors, like the formation of a bait ball, this behavior in aggregate has created opportunities for those of us on the outside looking to take advantage.

Sharks versus fish

The other analogy that I have often heard used to describe how the shift to passive/quant funds has affected active management is that of a poker tournament. The analogy goes something like this: As weak players, the fish, get knocked out of the tournament, the environment gets more and more competitive and good players, the sharks, are left to square off against one another. To put this into an investing context, as more and more investors choose to hold money passively, a red-ocean is formed among the actively-held float that makes outperformance by active managers increasingly difficult.

The problem with this argument, however, is that it assumes that price movements are always being driven by the reaction of active managers to new information. Indeed, I would agree with the poker tournament analogy in cases where the price reaction is a function of active managers updating their expectations for future cash flows. Any time you make an investment, you are betting that another investor (who is selling you the security) has gotten it wrong. If that other investor is another professional, the game becomes more difficult.

But in the current environment, price movements are not always driven by the buying and selling of the actively managed portion of the float. Shifts in and out of passive strategies, movements by quant strategies chasing some new factor as old factors decay – these have the potential to drive prices away from fundamental value. In these instances, the active managers who are following the situation all get to take a bite. The bait ball has formed.

Hedge fund manager Michael Burry, who Michael Lewis wrote about in The Big Short, recently expressed his concerns in a Bloomberg interview about a bubble forming in passive investing and the loss of price discovery when capital allocation decisions are increasingly made by investors following passive strategies. In the interview, Burry states:

“…passive investing has removed price discovery from the equity markets. The simple theses and the models that get people into sectors, factors, indexes, or ETFs and mutual funds mimicking those strategies -- these do not require the security-level analysis that is required for true price discovery. This is very much like the bubble in synthetic asset-backed CDOs before the Great Financial Crisis in that price-setting in that market was not done by fundamental security-level analysis, but by massive capital flows based on Nobel-approved models of risk that proved to be untrue.”

Irrationality lives inside the ball

Individual investor bias in response to new information does not by itself create mispricing. If one person’s bias is offset by another’s, then they tend to cancel each other out. This is the idea of uncorrelated errors that underpins wisdom of the crowd. It is only correlated errors – systematic bias in the same direction – that creates mispricing. In this sense, the growth in passive investing and quant strategies are a gift to active managers.

Why? Changes in price that have resulted from herd-like movements into and out of passive strategies, or from how a stock aligns with whatever factor is the flavor-of-the-day among quant funds, create the raw ingredients for behavioral mispricing. They are systematic, they are correlated, and they are often wrong from a fundamental point-of-view. I would argue that this creates a better environment for active management, not a more difficult one. The trick is knowing how to find the bait ball.

Searching for a bundle of correlated errors

The strategy for active managers in such an environment should be to sit patiently and observe the parts of the market where mistakes are most likely to be made. If we are in an environment like last December, there may be many opportunities. Other times there won’t be as many. The key is to understand how mispricing arises in the current environment and to then seek it out.

When you do finally see it, my advice is to sharpen your teeth, and take a swim through the middle of the bait ball with your mouth wide open.

A revolutionary initiative is helping average Americans find quick and lasting stock market success.

275% in one week on XLF - an index fund for the financial sector. Even 583%, in 7 days on XHB… an ETF of homebuilding companies in the S&P 500. 

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