t is no wonder that
the investment business can be so baffling to the uninitiated! In April
2016 the world's equity markets had just ended a punishing quarter.
Reflecting worries about the banking system and energy industry, among
other issues, the S&P 500 index suffered the worst beginning-of-year
decline in its history, while globally, stocks lost $5 trillion in
value. In 2017, by contrast, global stocks had their best start to a
year since 2012, rising 6.5%; the S&P had the best start in a couple of
years, gaining just over 6% in the quarter.
How can this be?
The stock market in the aggregate is supposed to be a weighing
mechanism, assigning values to the long-term prospects of businesses;
it’s the collective judgment of millions of participants. How could it
have been so wrong a year ago, seemingly anticipating future economic
difficulties only to see continued growth in business activity and
repeated new highs in stock prices during the balance of 2016, and
continuing into the new year? The seeming disconnect was even more
pronounced in 2008-2009. At the bottom of the financial panic at that
time, few would have ventured to predict an economic recovery
accompanied by a bull market in equities lasting several years, and
still counting.
The answer lies in
the fact that markets react emotionally in the short-term (like "voting
machines," according to investment thinker Benjamin Graham), reflecting
the fears among market participants about negative events that could
impact their lives and pocketbooks directly. At such times the default
position is the safety of cash. It is difficult to take a long-term view
when the world appears to be collapsing around you, as it really did
seem to many people in the fall of 2008.
Viewed from another
angle, dispassionately, the markets in 2008-2009, and early last year,
were correctly reflecting improved
investment returns going forward. A stoically inclined observer in
late 2008 and early 2009 would have noted that sharply lower securities
prices would mean notably higher future returns, all else being equal.
This is precisely what happened after 2009, and to a lesser extent last
year. The "all else being equal" reflects, of course, the risk that we
take when making these judgments. Judgments such as these, made in the
face of great uncertainty, represent to some extent leaps into the
unknown. But based as they are on historical precedent, they have tended
to work out well over time.
Once again we feel
compelled to comment on a remarkable phenomenon that, along with some of
the lowest interest rates in history, has to be one of the defining
characteristics of the current investment scene. This is the move away
from the careful, in-depth study of securities — the traditional search
for investment ideas, also known as "active investing" — in favor of the
group purchase of industries, sectors, or even entire markets through
vehicles such as index mutual funds and the newer exchange traded funds,
or "ETFs." The shift to these so-called "passive investment" tools has
been massive — ETFs alone drew in $131 billion in January and February of
2017, and $390 billion in 2016. Clearly the momentum is growing, and
investors need to be aware of the potential implications.
The move to passive
instruments is understandable. Traditional active investment managers,
who have been losing business to their passive competitors, have largely
themselves to blame for this state of affairs. Industry incentives
favoring asset gathering and short-term results have created a
bureaucratic behemoth that virtually guarantees mediocre returns. For
years indexed funds have produced better results for their customers
than their managed brethren. Radically lower fees and tax efficiency
adds to their appeal. They are also ideally suited for relatively small
amounts of money, such as periodic additions to IRA accounts over a
person’s working lifetime.
There are some
troubling aspects of the large-scale movement to passive investing,
however. Wall Street has responded to the indexing craze in its usual
way, creating indexes and funds to cover virtually every imaginable
subsector of the markets for securities of virtually every kind. It has
also encouraged the idea that investors can move among sectors, using
the funds to essentially make bets based on their opinions on which
group of stocks is most likely to do well next. This is a corruption of
the very idea of passive investing, which aims to do away with these
sorts of market calls. Many of the market segments targeted by passive
vehicles are populated by infrequently traded securities; ETF industry
protestations to the contrary, such products are largely untested and
carry the risk of suffering unexpected volatility or price collapse
during times of stress.
That fact that
passive products have reached a peak of popularity at this particular
time is a red flag. Interest in what seems to be "easy" investing tends
to grow after long stretches of positive market moves when investing
really does look easy to the uninitiated. 1999, at the end of the boom
in technology issues, was one such period, as is the current market
environment after an extended rise following the crisis period eight
years ago. During such periods equities frequently reach record
valuations. The "lost decade" experience of index buyers in 1999 should
stand as a warning. Unless you are an experienced and skilled investor,
buying an index can be a crapshoot, no matter how easy it seems. The
ability to distinguish between December 31, 1999 and March 9, 2009 — the
peak of a bubble and a crisis bottom respectively — is worth a lot of
money, even if you don’t get the dates exactly right.
Currently, the move
into passive funds might in itself be contributing to a dangerous run-up
in stock prices. In addition to being price-insensitive, index funds
typically hold far less cash that their active cousins. A move from
active to passive funds potentially releases billions of dollars of new
cash into an already expensive stock market.
Finally, there are
potential economic side effects to passive investing that tend to be
overlooked. A misallocation of capital occurs when funds buy securities
without regard to price or prospects. Indexes and the funds based on
them tend to favor larger companies whose shares are easily traded. It
has been pointed out that Exxon shares, for example, find their way into
ETFs focusing on "active beta," "momentum," "dividend growth," "deep
value," "quality," and "total earnings" strategies, not to mention
plain-vanilla S&P 500 products, despite the fact that Exxon’s results
have suffered as a result of a poor business environment in the energy
sector. But Exxon is a big company with a liquid stock that pays a
dividend, making it an easy target for funds of almost any stripe.
As rather inactive
"active" investors ourselves, we might be accused of criticizing a
competing approach. Nevertheless, we believe these concerns are valid
ones. Furthermore we have seen enough people be lured to simplistic
investment solutions over the years to know that they seldom pan out as
expected. Our standard dictum when dealing with fashionable investment
ideas applies — in finance it is usually unwise to do what everyone else
is doing.
Although
not as well known among the investing public as indexing and passive investing,
another band-wagon investment scheme has been gaining favor among
institutional money managers as market prices and valuations continue to
rise, creating fears of volatility or a future sell-off. Yes, nearly 30
years after the 1987 market collapse, when the U.S. stock market fell
22.6% in a single day, "portfolio insurance" is making a comeback,
reports the Financial Times. Memories fade along with the pain from past
mistakes, and the old ideas that caused them receive fresh interest from
those whose judgment is as limited as their investment horizons are
short.
Portfolio insurance
became popular in the 1980s as a way to protect stock portfolio values
in declining markets. Fundamentally it relied on "momentum," or the
tendency for a market trend to continue for a while. If a downward trend
appeared to be in place, funds sold index futures in the expectation the
trend would continue. The resulting gains in the futures market would
offset the declines in stock prices, at least to some extent.
Unfortunately, the strategy became so popular that selling begat even
more market declines and more index selling, resulting in a negative
feedback loop — thus the "Black Monday" crash.
On the surface at
least the new "crisis risk offset" schemes appear more sophisticated
than their forebears, employing tools such as hedge funds, computer
algorithms, and ETFs. Nevertheless there remains the essential reliance
on trend-following with the risk of negative feedbacks. At present the
amount of assets employing this type of protection appears to be
relatively small, so the risk of market-wide disruptions such as in
occurred 1987 is not great. That could change, however, if more
institutions adopt the methodology.
Why the sudden
interest in portfolio insurance? Much of the interest in the newest
incarnation of these tools has come largely from pension funds. The
failure of sponsors to properly fund their plans, poor market returns,
low interest rates, and increasing payouts to retirees have weakened the
funding status of many pension funds to a precarious state, making them
hypersensitive to market moves. We have always felt that if you are
going to invest in equities you must be indifferent to their regular and
sometimes violent fluctuations; that many funds are not, and seek safety
in speculative vehicles such as portfolio insurance, smacks of
desperation, not to mention poor judgment, in our view.
The ultimate
losers, if these schemes crash and burn, are the beneficiaries dependent
on income from their pension plans. More so than in 1987 they are
vulnerable to the vagaries of the market place, and more reliant on the
ability of their investment managers to generate a reasonable return.
With respect to these goals, portfolio "insurance" seems a misnomer.
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