Altus Insight August, 2017

The Altus Insight

Market news, commentary and relevant topics for today’s alternative asset investor
Date: August 31, 2017
FR: Forrest Jinks
RE: Passivity Passé

Sometimes the difficulty in writing about a concept is a lack of structured argument or support for or against the concept. Other times, it is just the sheer volume of data that can be overwhelming to filter down to a succinct message. This month’s topic definitely falls into the latter.

For the purpose of this article I am using Index Funds interchangeably with Exchange Traded Funds (ETFs). While realizing there are differences, and very important differences, those differences are not relevant for the purposes of this discussion.

The first index fund was started by what would later become Vanguard in 1975. The first ETF was rolled out until the early 1990s. Since that time “passive” investment strategies have continued to grow in popularity, the growth of which has exploded since 2009. Passive investment vehicles that track indexes now account for more than half of all investments made in US securities, and trade volume in ETFs is higher than all publicly traded stocks combined. Even more bizarre is that there are now more traded ETFs in the world than there are underlying stocks.

The idea behind ETFs is not a bad one, but as the investment world has shown an incredible aptitude for, this good idea has been blown so out of proportion that this good idea is no longer one (note: this comment shouldn’t be read as fact, but rather as this author’s opinion, justified only in part below due to volume constraints of an article such as this). My issues with the current ETF hysteria are both philosophical, which should have zero impact on analyzing investment strategy, and actual.

Philosophical:

  1. Stock markets are designed for two reasons. The first is to provide capital to growing companies. While a topic for a different article, that function has been severely impaired by current regulatory and monetary policies. The second is to provide a low-friction way for the public to invest. Those investments, in turn, act as a huge voting machine, rewarding companies that are doing a good job, and punishing those that are not. Passively managed funds have certainly reduced the friction of trading (and its associated costs) but by the very nature of passivity there is no discrimination in the purchase of stocks, therefore no “voting”. Good companies and bad companies are rewarded and punished alike. I don’t pretend we live in a true capitalistic economy, but I do still believe there is some element of rewards-based compensation. Passive investing destroys the very fabric of that extremely important part of our economy and society .

Actual:

  1. By definition, if I own an index fund (and assuming I stay invested in the index fund) I will have the same returns as the underlying set of companies contained in the index. It is definitionally impossible for me to beat the market under this strategy. Asset management firm GMO, managed by Jeremy Grantham, releases the GMO seven-year asset class forecast each quarter. These reports forecast what they expect the 7 year returns to be across a slew of asset classes including the main indexes, and they have proven to be amazingly accurate. Their current seven -year real-return forecast is a negative 2.3% per year for US large cap stocks, and a negative 1.6% annual return for US bonds. Of the broader categories, only Emerging Market stocks are forecast to offer a decent return of (still) only 4% per year. Are you happy with those returns? I am not.
    Responding to this issue of market-limited returns, creators of ETFs have devised all sorts of methods to invest in very precise slices of the market. You can buy an Obesity ETF (SLIM), a Farming ETF (BARN), a Sugar ETF (CANE), Aluminum (FOIL), and even Corn (CORN – yes, CORN, seriously). With this level of specificity, a conscious decision has to be made to invest in that product/segment. This is similar to investing in a stock, except without the additional benefit of knowing if the company(s) that make up the investment are worthy of it.
  2. There are three historical investment philosophies: value, growth and momentum.
    By their very nature, there is no value investing with investment vehicles that track indexes. Technically there will be growth companies in index funds and there are definitely growth-focused ETFs (although how those are defined is, of course, highly subjective).
    Momentum investing, however, is a more complex study.  Passive investment strategies have a deep impact on momentum investing, and vice versa. In fact, passive investing, in and of itself, creates its own momentum to a certain degree. Example: Money comes in to an index fund. That money then goes and buys the market. Not just the good stocks, or the growth stocks, or the undervalued stocks…all the stocks. This mandated purchasing pushes those prices up. Higher prices create excitement in the market and more money comes into the funds, driving the prices up farther. Articles are written about how great the stock market is doing and more money comes into the funds, pushing up the underlying stock prices. Ultimately, this cycle creates a stock market (S&P) that increases 13% since the election of a president that most of the country thinks is crazy, while coinciding with a time of underperforming economic growth, low corporate earnings growth, and increasing political turmoil. Momentum works. Until it doesn’t. Momentum-based trades, especially done in a macro (not security-specific) manner, can (and will) reverse with a vengeance. I have no idea when, in no small part because this level of passive investing, and this quantity of passive investment vehicles, is unprecedented; but it will happen.  
    ​This brings us back to the point in the first paragraph of the “Actual” section of this article. Index funds/ETFs are designed to perform in lockstep with the market/segment IF THE INVESTOR STAYS INVESTED. Because of the emotional/psychological impact of a falling market, very few investors stay the course. Studies have proven investors can’t consistently time the market, on neither entry nor exit. If investors aren’t staying invested in index funds they will underperform the market over a long time-frame.
  3. Warren Buffett says that if he doesn’t think an investment is a good investment for the next ten years he doesn’t want to be in it for the next ten minutes. A slightly different way of saying this is, if we don’t think an investment is worthy of all of our available investment we shouldn’t think it worthy of any of our investment (with acknowledgement of the importance of diversifying risk, etc.). A passive strategy indicates that all of our investment should be in passive vehicles. Imagine all of your investment dollars invested passively…Are you comfortable having your entire investment portfolio invested in investments that has absolutely NO ONE watching over it?
    1. This becomes more pronounced on a market-wide basis as an ever-increasing percentage of investment dollars flow into passive strategies. Fewer dollars invested with active managers has reduced the amount of resources those managers can spend researching/analyzing specific companies. Not only is no one watching the passive investment directly, but there are now fewer and fewer people in the market watching the underlying securities. No one is watching the hen house.
    2. When corporate bonds are issued, bond buyers analyze the opportunity, quantify the risk, and then assign a price they are willing to pay based on the risk. As there are changes to a particular market, industry or company, the pricing of the bond is adjusted based on the inputs. At least that is the way it used to work. Now, since nearly every possible new bond issuances are purchased by some sort of ETF or Index Fund, the inherent pricing function is degraded. The ETF has to buy a certain amount of a certain bond at whatever the market price is when they have the liquidity in hand, regardless of market conditions or pricing.
    3. The reduced flow of security-specific trades has reduced the liquidity of the underlying securities. This increases the bid/offer spreads and could create major issues come a market down turn. For those interested, google “mini flash crashes”. Though with little attention from the press, the quantity of such occurrences has increased dramatically over the past few years. Tying this point in with paragraph “b” above, not only are bond funds buying bonds regardless of market conditions, they are paying more for them than they used to, due to the reduction in liquidity in the market for each particular bond.
  4. The promised diversification often doesn’t exist. The “rules” for inclusion into any particular ETF can be complex and detailed. Usually the point is to buy the most diverse market representation of any particular strategy/segment. However, those same rules can end up creating a “diverse passive investment vehicle” that has a vast majority of its investment in only a few stocks. The Solactive Obesity Index “tracks the performance of companies positioned to profit from servicing the obese” and is the a-fore mentioned SLIM ETF. A whopping 40% of the ETF is tied up in only two stocks. Remember, neither of these stocks was selected in such volume because they are stock of good companies, growing companies, companies with high dividends, or any other such reason to select stock in a company. These stocks make up such a large weighting simply because they are large, and relate, in some form, to the fight against obesity.
  5. The construct of ETFs is discriminatory and the stocks in most ETFs would surprise most investors in that ETF. Picking on the same obesity-fighting ETF, SLIM…The ETF includes stock in a plus-size clothing company. Such a stock seems in direct opposition of the majority of the stocks in the ETF, which profit by reducing obesity. Betting on two opposing trends is generally not a good long-term investment strategy (Hedge strategy? Maybe. Investment strategy? No).
  6. Sometimes the best way to present an argument is through an example:
    1. Exxon Mobile (per information provided by Steve Bregman Horizon Kinetics in the Business Insider): Exxon is 25% of the iShares US Energy ETF and 22% of the Vanguard Energy ETF. It is both (and at the same time) a Dividend Growth Stock and a Deep Value stock. Almost unbelievably, it is both a Momentum Tilt stock AND a Low Volatility stock. For years, Exxon’s PE ratio stayed roughly around 10. In the last three years, it has increased to 48. FORTY-EIGHT(!), despite being a supposed blue-chip stock. What has occurred in the last 3 years? Oil prices have dropped 50%, Exxon revenue has dropped 45% and earnings have fallen 75%. So what has happened within ETFs? Exxon is such a large company that it has been picked up by over 200 ETFs with over 100 of those ETFs having Exxon as a top 15 holding. It truly is the law of supply and demand. Exxon checks so many ETF boxes, it has been in demand for (literally hundreds of) ETFs, and that demand has increased the price. In turn, the increase in price has required additional purchasing by those same ETFs when they rebalance (weekly, monthly, quarterly, etc.). The increased buying has further increased the price, again. It is the exact opposite of the death spiral. Wait, does that mean when the market turns that Exxon will then fall into a…death spiral?
    2. GURU: Quoting from www.etf.com, “GURU selects firms using a copycat approach, piggybacking on accomplished stock-pickers.” So let’s summarize: Index Funds and ETFs are growing in popularity because passive investment supposedly provides just as strong as returns as active managers, so we will then take our passive strategy and create an entire passive strategy based on the picks of active managers that we claim can’t create alpha in the first place? Seriously, you can’t make this stuff up.
  7. Some quick stats and fun facts for kicks and giggles:

    1. Vanguard, as only one of the many ETF issuers (though the largest) now owns 5% or more, of close to all the companies in the S&P 500. Since they are, by definition, not activist investors, this is a sizeable chunk of voting stock that is paying no attention to the performance, future, or governance of a company nor its leadership. Granted, on the flip side of this, it increases the voting power of the remaining 95% of the stock.
    2. Bloomberg’s ‘cliff notes’ on a study conducted by Bank of America Merrill Lynch, “The strategists found that stocks that had the highest passive ownership were more susceptible to price swings than the rest of the market because fewer shares were available for trading, exacerbating the impact on price.
    3. These supposed passive investment vehicles can be purchased in 2 or 3 times leverage. A four time leverage bond ETF was approved by regulators this month and will be rolled out shortly. We all know how leverage works on the way up and the way down. Ease of use for retail investors but with enough leverage clout that has taken out seasoned investment companies in the past.
    4. Researchers Israeli, Lee, and Sridharan (per Bloomberg), “A single percentage point increase in ETF ownership has demonstrable effects on an individual stock…over the ensuing year, correlation to the share’s industry group and the broader market ticks up 9%, while the relationship between its price and future earnings falls 14%...bid-ask spreads rise 1.6%.”

What does this mean in the long term? First of all, we probably shouldn’t throw the baby out with the bath water. There probably is a place for some amount of passive investment within our portfolio, but if we are going to go passive, we should really go and stay passive - Stay with the index funds or broadest ETFs. If you are going to sell on the way down, don’t do it out of fear. It is nearly impossible to time the market, but market mania-driven fear is 100% not the way to do it.

More importantly, the more the market becomes driven by passivity, counterintuitively, the more opportunities it will open for value investors to reestablish high value positions. When “good” and “bad” companies are treated equally by the market en masse, it will create buying opportunities in the “good” companies, especially relative to the “bad” companies. Momentum swings can’t help but be magnified, further providing discount buying opportunities.

Or maybe the securities markets become another giant Marxist experiment. No discernment, no reward for doing a good job. Just a massive pile of ambiguous securities holding hands and dancing around the Maypole.

Happy Investing!