Invest like Jedi

Despite headlines to the contrary, small taking share from big is a theme we will see plenty of in 2021, from ecommerce (Shopify) to challenger banks (Chime) to payment systems (Square).

We may even see some of it in investment management. After a decade of mutual funds losing share for charging too much for too little, Vanguard and Blackrock have become Goliaths. So far so good for the little guy saving on fees while avoiding underperformance, but what does the increasing dominance of passive mean? Let’s look at an example of how little guys can increasingly benefit from this growth of the passive fund “Goliath”.

This past Friday was an odd day in markets, and in particularly for the smaller companies in the Russell 2000 index. The Russell 2000 is filled with little banks, because unlike most sectors, there are so many – about 800 banks have tickers. A number of them, most close to $1 billion in assets, began soaring and plunging with 30 minutes to go before the market closed. None of them released news and there was nothing special taking place in the broader economy. Yet we saw First Western (MYFW), a bank that oversees a number of investment advisors, move 15%+ on meaningful volume:

Professional Holdings, which has a mortgage on a Trump property next to Mar a Lago, took a ride:

A little bank in Knoxville got nailed:

As did one on the coast of Maine:

Notice also the big trade at the beginning of the day for each of these companies.

What happened was both the Russell and S&P indices executed a quarterly rebalance.

There is now enough passive money in products lined up with these indices that 4 times a year, we can expect 20, 30 or even 50 little banks will take a ride on the Goliath rollercoaster, as State Street, Vanguard and Blackrock do their best to adjust allocations due to companies coming in and out of indices.

There is a science to this trend, and some firms predict adjustments, yet it still catches investors off guard. This is because:

a) Some ETFs are more organized about changes than others (note that some buy or sell stock on the open and some, in desperation, on the close).

b) Every year there are fewer dollars going to Davids taking the other side of these trades, and more dollars to the passive Goliaths.

c) These trades are often too small for many money managers to care about – perfect for little guys.

Little guys therefore need to keep slingshot handy for the money in these strange trades. This coming summer’s reconstitution stands to be the biggest roller coaster yet.