Chas Craig, BridgeTower Media Newswires
Since the world’s first index fund was created in 1975 to replicate the S&P 500, the value proposition for passive management has been that the average active manager is mathematically doomed to underperform the averages after fees, and stock prices already closely reflect intrinsic business values, leaving little room to add value through security selection. However, stocks have rarely if ever been set by the best informed or most rational investors, nor do they always reflect what the average investor thinks they are worth. Rather, the price of a stock during any given day is simply determined by the price at which the marginal buyer and seller agree to transact. Given the rise of passive equity investing, which has seen its market share of equity mutual fund assets grow from 4 percent in 1995 to 34 percent in 2015 (Financial Analyst Journal January/February 2016, Bogle), the natural result has been for asset allocation (investors’ preference for stocks generally) to supplant individual security analysis as the primary source of marginal price setting.
The implications of securities increasingly being priced at the margin by passive investors are far-reaching, for free market capitalism has proven to be the least bad system for allocating scarce resources. However, capitalism relies on discerning participants to determine who should be allocated capital and at what cost, so if stock prices are set more based on their weighting in an index than based on fundamental analysis, a drag on economic output could occur. Further, there are negative implications for corporate governance associated with many of our largest corporations being 10 percent to 20 percent owned by outwardly passive investors. These concerns are not new. In fact, at the outset in the mid-1970s index funds were labeled “Un-American” largely based on the preceding points. However, in 1975 these concerns were theoretical. Today, with $4 trillion in assets, these concerns have become much more practical.
Luckily, the current environment has provided an opportunity for active managers, as anything that causes markets to be less efficient offers us the opportunity to differentiate ourselves in a positive way. To frame the perceived opportunity, we first must explain the mechanics of the typical index fund. Most passive funds track the S&P 500 or other market-cap weighted index, meaning the larger the company, the larger its representation in the index. This means that as a company’s stock price increases the index fund is required to buy more of it with each new dollar that is allocated to the fund. Since the index fund community has enjoyed continuous and large inflows, their performance has benefited from the inherent momentum created by the market cap weighted nature of the index funds themselves. Since the way index funds allocate capital disregards valuations, there are now myriad examples where individual stocks, sectors and market cap groups have decoupled from long-term fundamental relationships with little other explanation available than the significant growth in passive investing.
In short, index funds buy more after a stock has gone up and buy less or sell after a stock has gone down. This sort of activity is counter to the way active managers following a value orientation operate, for unless they perceive the intrinsic value of the company to have changed commensurately, it is very likely that their discipline will dictate that they sell a position that has increased in price and buy more of something that has decreased in price.
Benjamin Graham once famously wrote that “In the short run, the market is a voting machine but in the long run, it is a weighing machine.” The implication here is that valuations will eventually matter, a lot.
While we believe there is an opportunity for sound active management to add meaningful value to an investor’s portfolio, it is likely that, consistent with history, only about 20 percent of actively managed mutual funds will outperform their benchmarks over the very long-term. We submit the following reasons for this unfortunate expectation:
• A Rich Man’s Problem – When active mutual funds provide excellent returns they often experience a significant inflow of “hot money.” When such fresh capital is deposited in the mutual fund the manager has three primary choices:
• He can increase his position size in his existing holdings, which have likely already increased in value significantly.
• He can increase the number of securities held, leaving less time for analysis per position and increasing the likelihood he will merely track the index.
• He can increase exposure to larger companies whose stocks are presumably already priced more efficiently than smaller companies.
• Manager Turnover – In addition to attracting fresh dollars as discussed above, top-performing funds also attract suitors for their star managers, so someone who buys into a mutual fund to gain exposure to a superior manager might be unpleasantly surprised to find out after a sustained period of under-performance that the only thing that stayed the same was the name of the mutual fund. This of course highlights one of investors’ duties to themselves, which is to keep abreast of important changes at the funds they hold if they choose to own actively managed mutual funds.
• Diseconomies of Scale – Also relating to growth in assets under management, trading larger blocks of shares results in a larger market impact and higher trading costs on average. Further, funds that successfully employ a given strategy will oftentimes find it difficult to achieve similar results with significantly larger amounts of capital to deploy.
• The Tendency to Herd – A study conducted by John Bogle and published in the January/ February 2016 edition of the Financial Analysts Journal found that 99 percent of the return of the average active mutual fund over the past 30 years could be explained statistically by movements in the index. This “closet indexing” cowardice persists because mutual fund managers are unlikely to be fired for a modest amount of underperformance, but a large negative showing can oftentimes result in investors fleeing the fund and the potential loss of employment for the manager.
• Brain Drain – Many young, hard-charging financiers that in yesteryears would have started their careers in an analyst position at a mutual fund family now take more lucrative positions at hedge funds, private equity firms or investment banks.
While the commentary above sounds quite depressing, the good news is that arrangements exist that when paired with competent managers can put the odds in investors’ favor of achieving better than average long-term results.
Given the structural challenges facing the active mutual fund industry discussed in last week’s column, it is a wonder that 20 percent of active equity mutual funds are still able to outperform their benchmarks over long periods of time. Active mutual fund returns are cited as representative of the returns for “active managers” simply because the data is readily available. However, not all active managers suffer from the headwinds facing active mutual funds. One such example is a private fund with limited liquidity, and another is the management of separate accounts paired with an investment advisory relationship. Below I have provided several qualities that are oftentimes characteristic of successful managers:
• Significant Insider Ownership – Managers that invest the grand majority of their personal capital in addition to their firm’s capital in the securities they own for their clients are very much aligned with the long-term success of their clients. Such insider ownership can be accomplished by directly owning the stocks they invest in for their clients or via investing alongside their clients in a pooled fund.
• Think for Themselves – Successful active managers pride themselves on conducting their research in an objective and rational manner without regard to what is currently popular on Wall Street. Managers that operate in this fashion will almost inevitably provide investment results that have a below-average correlation with the results of their respective benchmarks. While this approach being carried out by a competent and rational manager may be expected to add value over the long-term, periods of underperformance, potentially spanning several quarters or even years, will almost certainly occur from time to time.
• Growth is Controlled – Given the disadvantages (for clients) of significant scale in the asset management business discussed last week, some altruistic managers actually close their funds to new investors. Speaking from our experience in operating a boutique investment firm, a firm that is still actively seeking new investors should view their jobs in three roles in order of importance: 1) security analysts/financial advisers, 2) small business owners and 3) business development. To the extent that numbers 1 and 2 are done well, number 3 becomes much easier, and the resulting growth rate should be a manageable one.
• Often Not Widely Recognizable – With a few important exceptions, our experience has been that most successful investors view their investment ideas as valuable, proprietary information, and they attempt to carry out their investment operations in secrecy to the highest extent possible. It is for this very reason that this column will never discuss our thoughts regarding specific securities we own for our clients, as our investment ideas should only be for their benefit. This modus operandi is unlikely to make us or managers like us frequent guests on financial news networks.
We certainly are not suggesting that the presence of the above points assures any level of superior performance. However, we do believe that the conditions presented above are at least conducive to the successful implementation of an active investment program.
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Chas Craig is president of Meliora Capital in Tulsa (www.melcapital.com).
