The Death of Stock PickersSeptember 22, 2016
On August 13, 1979, BusinessWeek published a cover story by Barry Ritholtz titled, “The Death of Equities.” Ritholtz cited inflation and new opportunities for investors, specifically institutions, as the “death blow” to the roaring public equity market of the 1960s: a market which experienced annualized returns of 9% over a 40-year period. According to the author, these new opportunities were created by the Employee Retirement Income Security Act of 1974 (ERISA), which allowed pensions to invest into shares of small companies, real estate, commodity futures, gold and diamonds rather than only high-grade bonds and listed stocks.
1979 was on the heels of a decade of dismal performance for equities, where bonds yielded 11% and stocks returned roughly 3% annually. The article cited other asset classes that had demolished equities, stating, “…since 1968…stocks have appreciated by a disappointing compound annual rate of 3.1%, while the consumer price index has surged by 6.5%. By contrast, gold grew by an incredible 19.4%, diamonds by 11.8%, and single-family housing by 9.6%.”
The poor performance of stocks drove investors to pile into other asset classes. The article stated that at least seven million shareholders left the stock market between 1970 and 1979 with younger investors in particular avoiding the stock market. In ’79 high inflation was weighing down investors’ confidence in the market on the thinking that businesses couldn’t pass on the higher prices quickly enough and the fear that high inflation would lead to an economic downturn as it did in 1974. Ritholz summed up their mood, stating, “The old attitude of buying solid stocks as a cornerstone for one’s life savings and retirement has simply disappeared.”
Ritholtz isolated the movement of the herd and their perceived reasoning when he boldly made what would prove to be a costly assertion, that equities were dead. As of June 30, 2016, investors in the S&P 500 Index have experienced an 11.35% annualized return since the date of the publication in ’79.
Fast forward thirty-seven years, the market environment has set the stage to idolize a new trend and sling the proverbial death blow at another victim, the stock picker…dun dun dun. So in the spirit of “The Death of Equities,” let’s load up the arsenal to finally kill off those pesky stock pickers, because after all, they’re on their last leg.
For one, passive investments have a key advantage over active strategies — explicit costs. An investor can buy SPY, an ETF that tracks the S&P 500 for a few basis points while in some cases it may cost around 1.00% for an active manager that invests in the same universe. Furthermore, on aggregate active managers are having a hard time justifying that higher fee through their collective performance. The SPIVA Institutional Scorecard published by S&P highlights the struggle of active strategies in the large cap space to outperform the S&P 500 Index. As of June, 30, 2016, over 75% (84.15% (net), 76.23% (gross), and 85.81% (institutional) of all domestic Large Cap mutual funds have trailed the S&P 500 over a trailing five-year period, according to the report by S&P.
The mood of the market is that passive is smart. Over the last year, asset flows have greatly favored passive over active management, which continues a prior trend. According to Morningstar Direct Asset Flows Commentary, as of July 31, 2016, $211 billion (net) flowed out of active U.S. equity investments compared to $163.6 billion flowing into passive U.S. equity over the prior one-year period. On top of that, industry leaders in the institutional space such as CalPERS have increased their allocation to passive investments and place a strong emphasis on the impact of costs on their fund. CEM Benchmarking conducted an independent cost survey of the public plan and reported that CalPERS increased its use of lower cost passive and internal management from 64% of assets in 2010 to 69% in 2014.
So there you have it. Passive is cheap and everyone is doing it!
Looks like the stage is set to fire your active manger only to never see them again, right? Well, only if you don’t pay attention to the historical precedent of the herd plodding towards a good thing and distorting the pricing function of the market. “The Death of Equities” was a great example of a common behavioral tendency — call it a flaw — react with the mob to what has happened and fail to examine the future implications of their decisions. Calling for the death of stock pickers would also be an oversimplification and overreaction to the mood of the market without contemplating the aftermath. So before firing your manager due to the recent performance and asset flows relative to passive management, there are a few less obvious factors that may be putting extra air in the sails of passive strategies.
Currently, the global investment environment is one where major developed economies like Japan, Germany and Switzerland’s ten-year bonds are teetering on negative interest rates and the ten-year US Treasury is only yielding 1.67%. This is due in large part accommodative monetary policy from central banks around the world aiming to ignite their respective economies following the financial crisis of 2007. The low-yield environment means that current inflation expectations are relatively low and the opportunity to capture a meaningful real risk-free return on your capital is few and far between. In search of their long lost return, bond investors need to take more risk in spread products and the equity markets to attempt to meet their prior return expectations. Lower interest rates magnify the importance of fees in the investment decision because you are giving a higher proportion of your expected return towards your manager when your expected return is lower. The low-yield environment makes passive strategies a viable tool for investors looking to inch up the risk spectrum by adjusting their asset allocation from bonds to stocks.
When money flows into passive investments it creates demand for all of the underlying stocks that make up the index; that means the good, the bad and the ugly! This demand is created by the weight the company represents in the index, rather than fundamental factors like attractive growth prospects, valuations, or opportunities to unlock value for shareholders in the future. In essence, every stock is receiving a vote of confidence, much like a participation trophy. As more money flows into stocks through passive vehicles, the percentage of each company’s investor ownership that is not swayed by fundamental factors increases and price movement linked to fundamentals decreases. This shift creates higher return correlations between the winning and losing stocks in the real economy. It also creates an opportunity for stock prices to drift away from their true intrinsic value. At the extreme, a good company and a bad company can move closer to the same valuation.
In poker, as the chips move around the table there is a saying “easy come easy go.” This means that the quickest new money to move will likely keep moving, and in the case of the current market, this suggests that the low conviction money that flowed into passive investments from bonds and active strategies will be the first money to flow right back into bonds or active strategies if interest rates increase. So as the conditions that played into the positive performance of passive strategies unwind, it creates an environment where fundamentals may be at the forefront of performance trends. Fundamentally, people own stocks to participate in the future success of a business, not as a poker chip to trade around if the Fed looks like they may be bluffing on a rate hike. As attention moves away from monetary policy and toward the real economy, the stock market will price companies according to a more competitive environment, and the bad and ugly companies will have less passive demand to hide their flaws; just as players who received participation trophies may experience a rude awakening when they are rewarded according to their talent (or lack thereof). An active strategy aims to avoid the mispricing of bad and ugly businesses. Moving from active to passive based on short-term performance data may be firing your manager just when you need them most.
Whether you believe in the consistent efficiency of markets or you think a skilled professional can take calculated risks to better serve your capital goals should drive your decision between active and passive strategies. Furthermore, if you are pondering a switch from active to passive or vice-versa, chasing performance and asset flows may ultimately lead you to the worst timing to make such a change in course. While fees are important, they are one of many variables to consider when you think about the range of life altering outcomes you could receive when creating a long-term investment strategy. Don’t let the tail wag the dog and let fees and near-term performance be the ultimate factor driving your investment decision. “The Death of Equities” highlighted one of the many points in time when trends seemed like they would go on forever due to the recent performance of the market. As an investor, it is always important to think of the market implications when the masses are coming to the same “obvious” conclusions.
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This blog post was written by Tyler Mull, Investment Research Analyst for FDx Advisors.