Under the Hood: Diversification and the Active Manager, Part II

Indexation is unique inasmuch as there is no forecasted return associated with indexation. If the S&P 500 were to decline by 50%, this does not invalidate indexation. It’s merely the return that the index produced — it can’t underperform itself. Active managers, however, are evaluated relative to the index, though it is effectively impossible, in aggregate, for active managers to outperform the benchmark. What is necessary, then, is a departure from the investment behavior generally exhibited by active managers. They must be willing to eschew diversification to allow high conviction investments to grow as a share of their portfolio. In essence, they must behave in ways that the index cannot. Included herein are two of the best-known stocks in the world that anyone could have bought and held for a decade or two and become the top performing manager of their era. Not only didn’t any active manager do that, neither did any index, nor could any index have done so.

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Under the Hood: Diversification and the Active Manager, Part I

No concept in the investment world is as accepted as diversification. It is the most fundamental element of risk control. Almost by definition, active managers, in aggregate, cannot possibly outperform the S&P 500 since, collectively, the managers are simply the S&P 500 with expenses. Unfortunately for the active manager, there is no obvious answer to this argument. The only solution for active management is for those managers to be truly differentiated, trading indexation-based (uninformed) diversification for a focus on the specific areas of investment in which they can really add value.

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Under the Hood: Right on Schedule: Google + Facebook Versus AOL, 18 Years and Counting

Google and Facebook are centerpieces in the valuation and return distortions large-cap indexation is creating: in the first half of 2017, five stocks – just 1% of the S&P 500 index (“S&P 500”) holdings – were responsible for over one-quarter of the S&P 500’s return. In 2016, 25-odd names accounted for 50% of the index’s return; in 2015, just 10 stocks accounted for more than 100% of the S&P 500’s return. The impact of these stocks bears more than a little similarity to an ongoing discussion we had about the Internet, AOL and the Technology Bubble, nearly 20 years ago. These situations are not new, and they rarely end well. The only question is when.

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Under the Hood: When is A P/E Not a P/E, or How To Turn 90 into 22 in Three Easy Steps

How many times have we written about “semantic mis-investing”? That the description of an index or ETF does not necessarily mean that’s what you’re getting. Boring, no? Then, how about this: your ETF says the P/E of the holdings is 20x. But they exclude companies with negative P/Es, and almost entirely exclude companies with very high P/Es. That the P/E isn’t really 20x, that it’s really 40x? Read inside, see how it’s done.

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Under the Hood: The Indexation That Is, Versus The Indexation That Should Be

Most modern investors cannot beat an index consistently. This much is apparent. Most people cannot find a good manager and, even if they do, they will eventually dismiss that manager at the first sign of material underperformance. Therefore, it follows that, if possible, most people should be invested in a broadly diversified index like the S&P 500, or perhaps the Wilshire 5000.

Unfortunately, indexation as presented and advised at the current time is not to buy and hold broadly based indexes. It is asset-gathering, marketing, and fee enhancement at its finest. It bears much more similarity to consumer marketing than to investing. In fact, it is more or less what the active managers were doing when they had the upper hand.

The studies of managers proceed from the incorrect assumption that the active manager of the past was a well-intentioned Homo Economicus trying to find the best investment. Rather, though, Homo Economicus was trying to raise the maximum amount of assets and, ultimately, this impacted the stock selection decision. That led to the underperformance. The index manager of today is behaving precisely like the active manager of the past, and will soon exhibit the same outcome.

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Under the Hood: What’s in Your Index? Gold Miner ETFs

We bring up the precious metals companies because they have become a very popular area of investment interest, for obvious reasons.  Since the evolution of the ETF, gold has been able to play a role in portfolios as a hedge that was far more difficult in the pre-ETF days.  It’s important to understand how the investment objectives or expectations behind those reasons are satisfied or, perhaps, obstructed by the indexation vortex.  Bizarre stock price movements illustrates the premise that the efficient market is not at work in the gold miners ETFs. The high participation of leveraged ETFs in the gold miners’ group is influencing prices. Between the leveraged and the unleveraged index, the gold market has become a series of interlocking reflecting mirrors.

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Under the Hood: What’s in Your Index? The Value of Cash

For the first time since the late 1940s, stock and bond yields have essentially converged. Once upon a time – say for the prior 80 years – investors demanded higher yields from stocks since the risk was greater. So what does this mean? If nothing else, caution is in order, and investors should be very thoughtful, perhaps more than at any other time in their careers, about where capital is being put at risk and why.
Which brings us to cash and public companies. Cash earns effectively no income, and can lower various valuation metrics, which are surely also important to executive compensation and performance benchmarking. As a result, many investors wish for the cash on the balance sheet to be deployed — a nice word for “spent” – through share repurchases, dividends, or acquisitions. But this is only a productive use of cash if the transactions are done at attractive valuations, and without taking on more leverage than appropriate. As is usually the case, well, take a look.

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Under the Hood: 5000 Years of Interest Rates (Part II)

We’ve heard a lot about the historically low interest rates. But what does this mean? First, by historic, we mean in recorded history, so we’re already, in a sense, footnotes in a future economics textbook. Second, we really don’t want to be footnotes in a future financial markets textbook, as casualties of the greatest interest rate risk in history. But it appears that the potential impact from rising rates is underappreciated. The search for yield in all the ordinary places – long-term bond funds, REIT and utility funds, the ‘dividend aristocrats’ – is not diversification and it’s not safe. They’re at historic high valuations and it all hinges on interest rates. One must escape them, which means to step outside the indexation/ETF vortex.

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Under the Hood: 5000 Years of Interest Rates (Part I)

Keep hearing the phrase “historically low interest rates”? What do you think that means, exactly? Since World War II? Since the Great Depression? World War I? The Civil War? The War of 1812? What it means is “in the recorded history of mankind.” Meaning in the last 5,000 years. Near-zero and negative long-term interest rates, which are now a near-worldwide phenomenon, have never happened before. That should arouse at least a moment’s reflection, should it not?

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Under the Hood: What’s in Your Index? Why Utility Stocks Should Concern Income-Oriented Investors

As investors continue to search for yield in a persistent low interest rate environment, many are turning to “bond-like” securities, which offer high dividends and are perceived to be “safe.” These include utilities companies, which currently yield 3-4%, well above the yield offered by US 10-year Treasury Bonds. But the perceived safety rests on a precarious foundation. Simultaneous with their historic high valuations, they face serious risks that we do not believe are appreciated by most investors. These include: loss of marginal demand due to the rapid incursions of solar power, shrinking earnings as a result, and rising interest rates. Investors in utilities companies are urged to proceed with caution.

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Under the Hood: What’s in Your Index? The Beta Game – Part II

The Beta Game Part I described one of the most important ETF statistical measures: beta. Beta is important, even though all it does is measure the historical day-to-day price variance of a stock or index fund versus the S&P 500, because ETFs are generally sold on the basis of both high performance AND low volatility. In fact, all the high-beta labeled funds we could find had, in aggregate, less than ½ of 1% of the assets of funds labeled low-volatility.

In Part II, we give some explanation–since it doesn’t otherwise really make sense–as to how, by the measure of beta, India or Peru has lower risk than the S&P 500, and as to how horribly wrong past reliance on historical correlations has gone. (It was Mark Twain who popularized the following phrase–attributed to Benjamin Disraeli but without definitive authorship: There are three kinds of lies: lies, damned lies, and statistics.)

We also offer a proof that some of the best investors of the past 30 years cannot survive in a beta-driven world. And as a bonus, we’re even giving away a classically good investment idea, because having the best kind of high beta (yes, there is good high beta) we know it would fail to even be considered as an ETF or fund product.

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Under the Hood: What’s in Your Index? A New Bubble Indicator; Is One of Your Stocks In a Momentum ETF?

In yet another example of the ever widening gulf between fundamentals and valuation in the world of indexation – year-to-date, the S&P 500 was up 2.9% as of November 30, 2015; excluding just the 10 top contributing stocks, it was down 0.6% – momentum investing has become accepted practice. Momentum investing simply means buying stocks that have gone up (or, conversely, selling those that have not). Momentum indexes, and of course the ETFs that track them, create continued demand for those stocks that have risen recently, pushing them yet higher, while at the same time further pressuring the prices of stocks with recent underperformance. The momentum process is starkly different from the asset allocation process, and by design, seems likely to result in an unpleasant experience for those who are invested in (or perhaps anywhere near) momentum ETFs or the stocks that comprise them if/when the tide turns.

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Under the Hood: What’s in Your Index? The Beta Game – Part I

We have frequently observed that data without context is, at best, meaningless, and at worst, misleading. For many investors, beta (a statistical measure of the historical price risk of a stock or ETF relative to the broader market) has become among the most important factors in selecting an ETF. The implications for ETF providers can’t be ignored: demand for high beta ETFs is simply not there, so new ideas for high beta products are not likely to make it to market, while low beta products, no matter how irrational the beta may appear (e.g., does the Peru ETF really have the same beta as the S&P 500? Yes, it really does.), continue to gather assets. But if, as proposed in past commentaries, index constituent prices are driven by demand for ETFs rather than by the intrinsic value of the constituent companies themselves, what is the low beta of your ETF telling you?

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Under the Hood: What’s in Your Index? How Liquid is YOUR ETF, or What Does This Have to Do With Me?

Following the $1 trillion+ flow of post-2008 funds into index products such as ETFs, the valuations of the securities widely held in ETFs are driven more by demand for those ETFs than by the merits of the companies themselves. What would happen if that demand reversed – do the ETFs have sufficient liquidity to handle it? On August 24th, some of the most liquid ETFs experienced temporary, dramatic price drops though their constituent securities did not – the safety of indexation doesn’t feel so safe anymore.

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Under the Hood: What’s in Your Index? How to NOT Invest in the Dynamism of Emerging Markets: Through Your Emerging Markets ETF

Just as investing in high yield bond ETFs provides, paradoxically, little exposure to high yield bonds, investing in emerging markets ETFs does not really provide all that much emerging market exposure. The Indian market, for example, is exceptionally broad, with thousands of securities that participate in the economy’s robust growth. However, the ETFs that purport to provide exposure to the Indian market turn out to hold the same roughly 50 large-cap companies, companies that are either truly global in nature (minimal Indian exposure) or in great demand and quite expensive . If one seeks exposure to the local Indian economy, the current generation of ETFs are not the way to achieve it.

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Under the Hood: What’s in Your Index? Your Bond Index – Part of the ETF Bubble

For those dubious that indexation and the indiscriminate buying it has cultivated have massively distorted equity prices, the reality is startlingly clear viewed through the impartial valuation prism of bond prices. Attached is a brief excursion through an emerging markets high yield bond ETF. Care to guess the yield of a 10-year Republic of Lebanon bond? How about Russian Federation 7.5% of 2030? The terminal experience for investors may be quite different than they originally anticipated.

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Under the Hood: What’s in Your Index? International Diversification – Bet You Don’t Know How Much You’ve Got

In this first “Under the Hood: What’s in Your Index?” series, we test a widely held assumption in many (if not most) investors’ allocation decisions. Most investors have some portion of their equity portfolio assigned to international stocks to diversify their exposure to U.S. stocks. But what if, through a major index like the S&P 500, you’re already allocated (or over-allocated) to non-U.S. economies?

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