I Know EXACTLY How Your Index Fund Will Crash

Ah, the glory days of passive investing. Has there ever been a time when it paid so handsomely to be dumb money? While Wall Street Masters of the Universe close up shop and day traders fight to the death for every single basis point, Mom and Pop investors continue to grow rich with every passing day by blindly buying their Vanguard funds on a regular basis.

Hell, even Hedge Funds have stopped fighting the trend and joined the party. Business Insider recently reported that “Hedge funds are crushing it with a trade that anyone can replicate” noting that the best and the smartest are now basically buying up the emerging market ETFs (EEM, VWO) owing more than 12.4% of all outstanding shares.

It’s easy to believe that easy money will continue to flow. After all, the single decision bet of buying a cheap well-diversified ETF has been the most profitable investment idea of the past decade. No worries about risk control, commission costs or even selection bias. It’s done for you. Just set it and forget it as Ron Popeil used to say.

But mark my words this will end very badly for most investors and I know exactly how.

This week FT reported about the “Tech Tantrum” last Friday when many of the best known and biggest companies suddenly tumbled without a reason. What happened? As FT explains, an increasing number of institutional investors now use “factors” to allocate their money. Factors such as “growth” or “value” are the basic building blocks of market performance, and investors can try to cheaply and passively beat their benchmarks by tilting towards some that have shown to produce benchmark-beating returns over time.

“Indeed, the correlation of the “FAAMG” stocks – Facebook, Apple, Amazon, Microsoft and Google – to the growth, volatility and momentum factors are in the 92nd, 90th and 96th percentile respectively, Goldman Sachs noted on Friday. Tech has this year been even less volatile than utilities.

When tech began to buckle, reversing both their momentum and low-volatility factors, systematic funds would begin to sell, with nervous traditional mutual and hedge funds – which have piled into the sector this year – adding to the pressures.”

If all of this sounds familiar then you must be old, because I have only one word for you – 1987.

Yes if you are old enough to remember 1987 then you know how 25% of your whole net worth can be wiped out in a single market afternoon. At that time, the new fangled “program trading” system managed to create the biggest crash in market history.

Robots have no feelings and at a time when only 10% of all trades are proprietary, the soothing, vol dampening aspect of algorithmic trading which has created so much complacency in the market over the past 8 years can quickly morph into a death-defying momentum crush of the machines.

Almost no one believes that US equities could fall by 50% in one day which is precisely why it can and will happen. Because machines have no limits and will pound an asset down to zero if the algo rules suggest that to be the highest probability in the next hour.

So active traders, don’t despair. Your hard work and knowledge of risk control may protect you yet because in life passive never pays in the end.

Boris Schlossberg

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