Navigating the Passive Bubble during a Bubble – An Eas(ier)-Street to Alpha?

• Re-Introduction: Respect & Reverence for Mr. Bogle
• An Eas(ier)-Street to Alpha, Particularly for Large-Cap Managers
• The Fruits of Perfect Foresight
• Operating in the Unknown
• The Nature of the Profits on Offer
• Cash Burners: Can Kailash Help Make Sense of the Money-Losing Morass
• Putting it All Together: The Long and The Short of It
• Conclusions
• Addendum: Picking from the Profitable Need Not Be Painful
• Exhibits

Re-Introduction: We Have Chosen to Reprint our Comments from Part I of Our Series to Avoid Potential Confusion

The media seems to be moving toward communications where the emphasis is on the titular rather than the knowledgeable and where tweets take precedence over any contemplation requiring more than 143 characters. No such thing is underway here at Kailash. We do our best to deal in data-driven facts and admit that we are flawed as both people and researchers.

John Bogle brought investing to the public in a manner that has undeniably done a better job than the typical active manager. While the titanic amounts of money flowing from…everyone…to the firm that Mr. Bogle created, Vanguard, which now has AUM north of $4 trillion¹ dollars, one is wise to contemplate Princeton economist Burton Malkiel’s quote that “…it’s easy to forget how courageous and tenacious Jack Bogle was in starting [passive products].”² That Mr. Bogle has built a behemoth of such magnitude in a manner that has left his net worth so modest³ (relative to his firm’s astounding success) is further testament to his commitment to shareholders’ well-being. We at Kailash have nothing but respect for the house that Mr. Bogle built.

The purpose of this piece is merely to note that one might suggest that we have reached an inflection point where disciplined, process-driven investors may face uncommonly good odds and a relatively simple path to outperforming the indices for their shareholders. After all, if everyone is passive then, by definition, no one is watching management anymore.

In reading the data from Morningstar there are two notable figures that stand out to us in particular:

1. “Thanks to the record flows into passive U.S. equity funds, the overall inflows tally for U.S. stock funds hit its highestmonthly total [in December] since April 2000.” Emphasis ours
2. The biggest “donors” of AUM from active to passive in equities are Large Cap products where active Large Blend & Growthproducts lost over $170 billion in assets with $143 billion of that showing up as purchases in the Large Blend passive category

Summarily, while we have deep respect and admiration for “all that Bogle wrought” we are, by nature and inclination, folks who go where others are leaving and try and look to exit places we feel are becoming crowded. History indicates that herding behavior like we are seeing into passive products, particularly in Large Cap, is probably evidence of too much of a good thing. As documented by many an active manager that we speak with, we believe that the mania for passive is creating a circular and self-reinforcing set of purchase orders that reinforces the positive price performance of larger weighted firms regardless of their fundamentals while putting relentless pressure on stocks that might naturally attract disciplined active managers (those who seek uncommonly strong fundamentals relative to price in particular) by redeeming them and forcing them to sell.

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The information, data, analyses, and opinions presented herein (a) do not constitute investment advice, (b) are provided solely for informational purposes and therefore are not, individually or collectively, an offer to buy or sell a security, (c) are not warranted to be correct, complete or accurate, and (d) are subject to change without notice. Kailash Capital, LLC and its affiliates (collectively, “Kailash Capital”) shall not be responsible for any trading decisions, damages or other losses resulting from, or related to, the information, data, analyses or opinions or their use. The information herein may not be reproduced or retransmitted in any manner without the prior written consent of Kailash Capital. In preparing the information, data, analyses, and opinions presented herein, Kailash Capital has obtained data, statistics, and information from sources it believes to be reliable. Kailash Capital, however, does not perform an audit or seeks independent verification of any of the data, statistics, and information it receives. Kailash Capital and its affiliates do not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only and is not intended to provide, and should not be relied on for tax, legal, or accounting advice. You should consult your tax, legal, and accounting advisors before engaging in any transaction. © 2021 Kailash Capital, LLC – All rights reserved.

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