Dennis C. Butler, President
of all guest columns written by Dennis C. Butler, CFA
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; itís 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 personís 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 donít 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 Exxonís 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.
. ________________________________Dennis C. Butler, CFA, is president of Centre Street Cambridge Corporation, investment counsel. He has been a practitioner in the investment field for over 33 years and has been published in Barron's. He holds an MBA from Wharton and a BA in History from Brown University. His quarterly newsletter can be found at www.businessforum.com/cscc.html.
"Current low valuations reward the long-term view", an article by Dennis Butler, appears in the May 7, 2009 issue of the Financial Times (page 28). "Intelligent Individual Investor", an article by Dennis Butler, appears in the December 2, 2008 issue of NYSSA News, a magazine published by the New Yorks Society of Security Analsysts, Inc. "Benjamin Graham in Perspective", an article by Dennis Butler, appears in the Summer 2006 issue of Financial History, a magazine published by the Museum of American Finance in New York City. To correspond with him directly and /or to obtain a reprint of his featured articles, "Gold Coffin?" in Barron's (March 23, 1998, Volume LXXVIII, No. 12, page 62) or "What Speculation?" in Barron's (September 15, 1997, Volume LXXVII, No. 37, page 58), he may be contacted at:
Centre Street Cambridge Corporation
Post Office Box 390085
Cambridge, Massachusetts 02139
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© Copyright 2017 Dennis C. Butler, All Rights Reserved
Revised: April 7, 2017 TAF
© Copyright 2017 Dennis C. Butler, All Rights Reserved