Stock managers sick of being steamrolled by the onslaught of passive funds may have a new weapon to wield, one that was born of the very success their enemies had in overrunning the market.
According to quant strategists at Deutsche Bank, investors can beat equity benchmarks by building portfolios out of stocks that get whipped around the most when exchange-traded funds rebalance.
Bet against the ones they buy, and buy the ones they sell, is what they recommend. If all you did was go long stocks with the most negative ETF flows over the last 12 years, you would’ve topped the Russell 3000 Index by 2 percentage points annually. Buying and shorting returned 7.2 percent a year, the firms says. That’s more than double the best-performer among 10 factors tracked by Bloomberg over the period.
So enamored are they with their findings that Deutsche Bank strategists led by Ronnie Shah are treating it as the discovery of a new investment anomaly, a systematic way of profiting from errors in investor thinking.
In this case, they say, the error is when traders sense price trends being created by ETF flows, jump in and make them bigger. Since buying and selling by ETFs doesn’t reflect any company-specific knowledge, the trends later reverse, the study holds.
“The proliferation of passive investments is causing distortions,” said Shah, the firm’s head of U.S. quantitative equity strategy. “It’s a new anomaly associated with ETF flows that active managers can take advantage of.”
His team is among a growing group of market watchers who seek an edge by studying ETF behavior at a time when indexes outnumber stocks and passive vehicles control more than one fifth of the market cap of the S&P 500 and Russell 2000 indexes.
While hedge funds and other speculators have devised any number of strategies to front-run and otherwise exploit passive flows, Shah is among the first to publish a model for doing so over time using rule-based inputs. The success of the strategy relies on the popularity of passive investing, he said.
Lots of trading systems generate big returns on paper and then fail to live up to their promise when let loose in the real world. Shah noted that his model didn’t turn a profit until 2009, when the active-to-passive rotation accelerated. That’s also when the bull market began, leading one analyst to question if it’s a coincidence.
“Seeing anything turn around in 2009, you have to wonder whether it’s just a good, up market strategy,” said Melissa Brown, head of applied research at Axioma Inc., a provider of tools for risk management and portfolio construction.