I just read an interview with retired fund manager Bob Rodriguez who managed award winning FPA mutual funds in stocks and bonds. Like us, Rodriguez believes in owning cash when there is a storm on the horizon and he held significant amounts of cash (30-40%) in 2000 and 2008 in his actively managed stock mutual fund. He is now retired but he is seeing a perfect storm developing thanks to the huge shift into passive management where there are NO cash holdings. When the next downturn hits, many of those invested strictly in passive instruments will likely be hit extremely hard and their timing will be poor to hit the sell button. Here are his insights on the coming storm:

The public looks at these outcomes and says, “Why should I pay higher fees to managers who can’t outperform or can’t even identify a major speculative blow off. I might as well be fully invested. I might as well be in an ETF or index fund.”

Thus, since 2007, indexing or passive activities have risen from approximately 7% to 9% of total managed assets to almost 40%. As you shift assets from active managers to passive managers, they buy an index. The index is capital weighed, which means more and more money is going into fewer and fewer stocks.

We’ve seen this act before. If you didn’t own the nifty 50 stocks in the early 1970s, you underperformed and, thus, money continued to go into them. If you were a growth stock manager in 1998-1999 and you were not buying “net” stocks, you underperformed and were fired. More and more money went into fewer and fewer stocks. Today you have a similar case with the FANG stocks. More and more money is being deployed into a narrower and narrower area. In each case, this trend did not ended well.

When the markets finally do break, as they always have historically, ETFs and index funds will be destabilizing influences, because fear will enter the marketplace. A higher percentage of assets will be in indexed funds and ETFs. Investors will hit the “sell” button. All you have to ask is two words, “To whom?” To whom do I sell? Index funds and ETFs don’t carry any cash reserves. The active managers have been diminished in size, and most of them aren’t carrying high levels of liquidity for fear of business risk.

We are witnessing the development of a “perfect storm.”

Header photo from Unsplash Breno Machado