Passive Should Never Laugh At Active

I have been meaning to write this post for quite some time. As an ex-ETF trader, I have watched with bemusement as investors have both embraced and shuddered at the wide adoption of ETFs. But most pundits are missing the larger picture. ETFs are just a symptom of the bigger phenomenon. The true battle lies in the passive versus active debate.

Let me get this out of the way right off the bat. I have no dog in this hunt. I see both the benefits and the negatives to each side. Yet as a trader, I definitely have a view on which end of the boat is leaning lopsided right now.

Lessons from triple witching

But first, let me tell you a story. I was lucky enough to have a ringside seat for the coming of age of equity index derivatives. Sure they existed before my time, but the true widespread global adoption occurred in the 1990’s. In Canada, when I first sat down on the institutional desk, clients had little interest in what the young kids with their fancy SUN workstations were doing. Yet as money flowed into the derivatives complex, what had first just been a strange little science experiment, suddenly started moving the underlying market. Our index arbitrage flows became significant, and regular plain vanilla clients began took notice.

Along with the increased index arbitrage flows came this bizarre triple witching expiry. When open interest was small, these expiries were minor. But as the usage of derivatives expanded, one morning we experienced an imbalance that was uncomfortably large. Being index traders, we instantly understood what had happened. Someone was letting a whole bunch of exposure expire into the open, and therefore there was a very large, and very real, index sell basket to execute at the open.

Many institutional clients were not used to trading on the open. Most often, they let retail orders and market makers set the price, and then after it settled down, they would give us their orders.

Given that institutional clients were not interested in trading at the open, there was little liquidity for the large expiring sell basket. Sensing an opportunity, we bid spec for a decent portion of the sell imbalance, hoping to get a good fill which we could then offset in the futures market. The trouble was, not nearly enough market participants joined us, and the market gapped down huge. It was a terrific trade as the opening settlement was many hundreds of basis points below the previous close.

There was no fundamental reason for the market dislocation. It was simply a matter that not enough participants understood what was happening.

Rest assured, immediately after the violent open, our phones were ringing off the hook with clients wanting to understand what the hell happened.

With some education, active managers learned how they could take advantage of this liquidity demand at expiry, and from then on, these fundamentals clients lined up to offset the morning imbalances.

And that’s how markets work. Opportunities are arbitraged away by market participants attempting to take advantage of mis-pricings.

End zone dances are a bad idea

When I see a passive manager making fun of a fundamental investor, I am perplexed. The passive manager’s very existence relies on fundamental investors keeping markets efficient. You can’t claim the market is too efficient to beat, therefore you shouldn’t try, and then laugh at everyone who does. The paradox is that your success as an indexer depends on everyone else continuing to try. The passive investor should be thanking the active guys, not mocking them.

Which brings me to a twitter exchange that I watched this weekend. I won’t name names because it isn’t important, but it was between two popular market pundits – an extremely well known money manager (and social media star), and the other, a semi-retired macro manager, revered within the hedge fund community. What struck me as odd was that the money manager, seemingly-out-of-the-blue, posted an article from last year where the macro manager had forecasted an increased chance of a recession in the coming year. The problem was that he had included a big LOL with the date on it to show how badly this macro guy had whiffed.