In this post I’m going to offer some additional points on the whole active management vs index debate, as well as discuss some of the very large distortions that ETFs in particular are creating.
I too often hear people arguing for one side over the other but this misses the point. It’s not a question of whether one style is better than the other, but rather, which style tends to perform better during certain market environments and which style is right for you as an investor. Below is a chart showing the percentage of funds that beat the S&P 500 Index on a 5-year rolling basis. Notice how it moves in cycles and, historically, the number tends to decline during bull markets.
As I discussed last month, active management almost always outperforms during rough periods in the stock market (which, by the way, is mathematically more important than outperforming during the good years) due to higher levels of cash and a value conscious approach to buying and selling. The more high quality a portfolio is, the more it should underperform during a strong bull market – especially one boosted by ultra low interest rates and Quantitative Easing as these act as lifelines for struggling companies, sending their stocks screaming higher as they’re saved from the brink of bankruptcy.
The price-insensitive nature of Exchange Traded Fund (ETF) indexes in particular has created some very odd and glaring disconnects in the markets the past few years. Not only is it making the stock market dumber, it has also created a bit of self-reinforcing, reflexive nature to markets (i.e. good performance attracts more money which leads to disproportional buying which further pushes up the index). As well as it has worked for investors that own an ETF on the way up, one has to wonder if it will be equally as bad, if not worse, on the way down. I tend to think that it has to and at this point I’m trying to avoid new investments in securities with a high weighting in ETF indexes. These securities have likely been pushed above their true value while securities not included in various indices are being ignored to the point that they’re undervalued. This is where the opportunity lies. It then becomes a question of when will this be recognized and “corrected” in the market. If history is any guide, the answer is during the next bear market as it typically coincides with fund outflows. Case in point is how small cap value stocks did so well during the bear market from 2000-2002 that followed the bursting of the tech bubble.
Below is a link to an excellent video of a speech by Steven Bregman at Jim Grant’s investment conference highlighting some of the dislocations that ETFs in particular have created in the investment markets. I highly recommend that you watch this video if you want to understand some of the nuances in today’s markets, and especially so if you manage investments (for yourself or others) and use ETFs. As the speaker points out, the concept of indexation is not the problem. The issues are being created by the structure of ETFs.
This is the third time this cycle has played out in the last 20 years. Investors flocking to Vanguard in droves are basically driving using only the rearview mirror. But hey, their unwillingness to do any sort of research or thinking is our advantage.
Equity ETF fund flows
Source: Yardeni Research
“What could be more advantageous in an intellectual contest – whether it be bridge, chess, or stock selection than to have opponents who have been taught that thinking is a waste of energy?” –Warren Buffett, 1985 Berkshire Hathaway Letter to Shareholders
-Nick