The active investment management industry has earned itself a terrible name. Two thirds of all equity mutual funds in the US underperform the S&P 500. What is worse is that, as a group, investors in mutual funds underperform the funds themselves because of mistimed entries and exits. Fees on actively managed funds including entry and exit loads are high. Their fees have made asset management companies and their star investment managers rich while delivering mediocre performances for investors. One is reminded of the title of a popular book about Wall Street called “Where are the customers’ yachts?” When one looks at what is going on in the hedge fund industry, the situation is even more appalling. Hedge Funds on average have underperformed consistently and failed to deliver value despite charging egregiously high fees. No wonder then that there is a big backlash in the public pension space against allocations to hedge funds and a push toward passive investing at much lower costs.
Warren Buffett in his letters to investors calls people in the investment management industry “helpers” who are out to take the wealthy “Gotrocks” family for a ride. He recommends that investors should fire (i.e. redeem) all their active managers and instead allocate a fixed amount periodically to a low cost index fund like Vanguard that replicates the S&P 500 index. It seems like the investing public is listening. Over the previous ten years, assets under management in actively managed mutual funds have declined as investors have shifted assets to passive funds like Vanguard and Exchange Traded Funds (ETFs). Interestingly this has put into motion two negative self fulfilling cycles. As more money heads into passive strategies, index stocks outperform non index stocks leading to further underperformance and consequent redemptions from active management. Also, as active managers become more obsessed with tracking error and benchmark underperformance, they start closet indexing their portfolios to reflect pseudo-index funds. With interest rates near zero and flows into equity markets continuing unabated, it appears like investors have discovered a new alchemy in passive investing.
It is important to stop for a moment and think about the staggering nature of the shift underway.This has very large consequences for investing and investors. If investing is all about flows and all about supply and demand of a particular security then the underlying and fundamentals do not matter. This would then be the anti-thesis of the fundamental value investing hypothesis proposed by Benjamin Graham that the market is a voting machine in the short term and a weighing machine in the long term.
If there is any truth to Benjamin Graham’s hypothesis, the weighing machine will eventually overpower the voting machine. Given the size and duration of the passive investment trend, it is inevitable that equity indices and their linked passive investors will endure very long periods of underperformance. On the other hand, disciplined active investors who know what they are doing (a dwindling lot) will likely outperform the consensus for an extended period.
The dictionary defines suspension of disbelief as a willingness to suspend one's critical faculties and believe the unbelievable. Suspension of disbelief is essential for the enjoyment of works of fiction like movies, books, magic shows etc. However, we humans seem to excel in the art of disbelief suspension in many other areas of our lives as well. Investing is at the top of that list.
In the words of Warren Buffett, price is what you pay and value is what you get. But investing based on value is very difficult to practice. Investing based on value requires one to take a position that the market is wrong. Our belief in prices set by the market or to put another way, our willingness to suspend disbelief about the prices set by the market makes it hard for us to disagree with the value ascribed by those prices. Once the link between the price of a security and the value of its underlying asset is broken due to the voluntary suspension of disbelief by market participants, interesting things start to happen.
Benjamin Graham noted that the market then becomes a voting machine instead of a weighing machine and success begets success and failure begets failure. Graham had said that the markets behave like a voting machine in the short term and a weighing machine in the long term. Unfortunately he did not define the duration of the long term. John Maynard Keynes on the hand did articulate it and said that in the long term we are all dead.
Recent experience in the markets would make one believe that the long term in the market is nothing but a series of short terms and since the market behaves like a voting machine in the short term, it should theoretically also behave the same way in the long term. This hypothesis is being proved by the rise and rise of passive index based investing. The most recent semiannual report on fund manager returns produced by S&P Global (SPIVA report) showed that 90% of actively managed US mutual funds underperformed their benchmark indices. As an active money manager and one who makes a living picking stocks, I have managed to find myself in the 10% of managers who do beat their benchmarks. However, I can tell you from experience that it has been incredibly hard to beat the index and it is getting increasingly harder to do so.
As more money goes into passive index based funds, demand for securities that make up the indices increases and their trading volumes and liquidity increases. The increase in demand leads to higher prices for the indices and securities thereby creating more demand of index based funds. As money skews towards indices and their components, it moves away from non index securities thereby depressing their prices, trading volumes and liquidity. This amplifies the perception that securities in the index are safer than those not in the index and that larger companies, which by definition are in the index, are safer investments than smaller companies. This phenomenon is exaggerated in emerging markets which are less liquid to begin with and are dependent on foreign capital flows.
It is important then to step away from this madness and ask whether the value of the underlying matters? Does the market ever behave like a weighing machine? Can the fictional and voluntary suspension of disbelief result in the emergence of an alternate reality? If we truly are in an alternate reality then again in the words of Warren Buffett, I am out of touch with present conditions, and if not then I believe that this has to all end very badly.
I would like to take this opportunity to wish all readers of my blog a very happy and profitable new year. The world is a crazy place and seems to be getting crazier. Stay safe, stay optimistic and in the words of Johnny Walker, "Keep Walking!"
In the words of Yogi Berra, "It is tough to make predictions, especially about the future." But, it is even tougher to write a new year blog post without making predictions. So, continuing with the clichés, here I go putting my foot in my mouth and painting myself into a corner.
Despite my optimistic predisposition towards life in general, some things are clearly visible to the naked eye and refusing to believe them makes one delusional. Therefore, 2016 is going to be a tough year for Brazil, Russia, China, South Africa (the BRICS minus India) and as a result for emerging and frontier markets across the board. They have a lot of structural issues to sort out and these things by their nature take time. India has been sorting out its structural issues for the last few years and the light at the end of the tunnel is now visible. This makes India the lonely BRIC that is likely to have a stable economy in the first half of 2016 and a potentially accelerating economy into the second half of 2016 and well into 2017 and 2018 in a cohort that is in trouble.
The interesting challenge for investors in India will be dealing with the duality of a downward drag from emerging markets and an upward pull from domestic growth. The result, in my opinion, will be a market that is likely to completely divide into two. Any industry/sector that is uncoupled from imports and exports either directly or indirectly (pricing power) is likely to see a wall of money descend on it. And those that are affected by the goings on in other emerging markets are likely to wallow in misery. Given that the supply of domestically driven stocks is limited and their float is even smaller, ridiculous valuations will drive a gigantic revival of the primary markets in the such sectors. To the envy of public markets investors, this will make venture capital investors look like rock-stars. This will likely funnel even more money into early stage investments leading to a frenzied blow-off. The nearest analogue in history to the scenario that is likely to play out is the technology, media and telecom (TMT) boom of the late nineties. Those looking for a repeat of the broad based emerging market (and easy money) driven run of 2004-2007 are likely to be left holding a lot of lemons. India therefore will be an exciting and difficult place for investors in 2016 and it will behave like a lonely survivor in stormy waters. The financial markets as always will give us plenty to do and will keep us busy in 2016.
My concluding cliché then; may your stocks go up in 2016 and if they don't, may you not buy them!