Question

To exploit a passive investing 'bubble' how would shorting the funds through buy puts or sell calls work? Or would incorporating a small cap index be better - how would this work? What would be the best investment strategy to exploit it?

Answer 1

Passive investing has been one of the most commonly followed themes by investors in recent decades and now accounts for a huge share in total investment management business. Large cap Index funds and ETFs have provided investors with very sophisticated tools to deploy the passive investment strategy.

This has brought immense liquidity and capital into the index funds (& therefore the underlying large cap stocks) which has definitely played at least some part in pushing the prices and thus valuation multiples of large cap stocks higher.

If an investor believes that due to passive investing, the large cap stocks (& the index funds based on them) have attracted disproportionate amount of liquidity which has pushed their prices to overvalued levels and they are due for a correction, following could be few strategies that could be employed to benefit from it:

• Buy puts: One way to benefit from a fall in price in anything is to buy put options. Put option is an option to sell a security (ETFs in our case) at a predetermined price (called strike price) at a future date. If the price of the underlying security goes down during the option period, the price of the option would go up and hence, profits would be made.
• Sell calls: Another way to benefit from an expected fall in prices is to write call options. A call option is an option to buy a security (ETFs in our case) at a predetermined price (called strike price) at a future date. If the price of the stock goes down, the party who sold the option and received premium would benefit from it. However, the maximum profit with this strategy is limited to the option premium received at the time of transaction and therefore, this strategy has limitations
• Small cap index: If an investor believes that large cap index funds have attracted disproportionate amount of capital as compared to mid cap and small cap index funds which has artificially deflated the value of mid cap and small funds, the investor could benefit from it by investing in the said mid cap & small funds if he is of the opinion that they are truly undervalued based on fundamental analysis and that the liquidity flow is set to correct.

Best investment strategy

The two most important variables that must be considered in this situation is to first analyse if the values of large cap index funds are actually significantly higher than their fundamental values or not. Secondly, are mid cap and small cap indexes significantly undervalued from their fundamental values or not.

Once an investor is sure that log term index funds are significantly overvalued, buying the put option (with maturity in line with expected correction) is the best strategy as the risk is limited to the premium paid and their is no limit on potential profits. Again, the maturity period of options must be in line with expected time the investor believes large cap prices will take to correct. If it's expected to correct in 6 months, than a 6 month option period must be bought.

Further, if an investor is confident that that mid cap and small indexes are also significantly undervalued, he may benefit with investing in these index funds as well by either buying them directly or buying call options with suitable maturity