Most investors think quality, as opposed to price, is the determinant of whether something is risky. But high-quality assets can be risky, and low-quality assets can be safe. It’s just a matter of the price paid for them.
– Howard Marks (Sept 2015)
It seems not a day goes by where a media outlet or publication doesn’t run a story on the death of active management. Whether these stories note the current tidal wave of money being dumped into low-cost index mutual funds and exchange traded funds (ETFs) or the idea that some large percentage of active managers fail to beat their benchmark, it’s all the same story. Even notable investing legend Warren Buffett in his annual letter to shareholders recommended that individuals allocate almost all their investable assets to an S&P 500 index. Everywhere you turn, the drumbeat of passive investing is audible. But is it a siren’s song?
Doesn’t it strike you as odd that humans spend countless hours getting the “best deal” on items to include toothpaste, cable bills, gasoline, and groceries, and yet do not put in equal amounts of effort to a far more critical commodity: their financial assets? Put another way, the word “deal” as described in the prior sentence is meant to imply a recognition of price consciousness. The passive approach to investing mandates that you ignore your inner drive for price consciousness. To me, this behavior seems a little strange, but recent flow of funds data would suggest that many investors are, in fact, eschewing price consciousness in favor of simple “market exposure”….just as the equity markets touch new all-time highs.
As with other manias in financial markets history, we think what is really going on here is momentum investing. In financial markets, the phenomenon of momentum refers to the positive feedback loop that is created by prices that go up over a short/intermediate-term time frame. This upward bias in prices draws in additional investors near the mid-to-latter stages of the cycle as FOMO (Fear Of Missing Out) creates a buying frenzy. Investor memories can be myopic, and you don’t have to look hard for examples of this activity. Some would include: technology stocks in the late 1990s, single family homes in the mid-2000s, master limited partnerships (MLPs) in the 2010s, and the soup du jour is exchange traded funds (ETFs) based on indices.
So why is it a problem that so many investors are now price insensitive, and how are we (Gratus) accounting for this new potential risk? We touched on this topic in an update last year, but I believe it’s time to revisit the issue as the answer may not seem obvious.
Low Cost ≠ Low Risk
We’ve put this idea first, as we think it is the most important concept to consider when thinking about an ETF or index mutual fund. Just because the vehicle is low cost (ETF/index mutual fund) does not mean that the assets underlying the vehicle do not carry risk of over-valuation. Many in the financial media will eschew this point by saying something nebulous like “in the long run” or “over a full market cycle” to indicate why your entry point is irrelevant. To us, these phrases are meaningless, because every investor’s time horizon is different and considerations around their financial assets are unique to some degree. So to reinforce the point, just because you can buy an index that has a low management fee does not mean you aren’t paying too much for the underlying assets.
Someone Needs To Do The Hard Work
To us (as we’ve mentioned in prior publications) successful investing all comes down to basic probability analysis and, by extension, risk/reward. The only way we know how to pass judgment on risk versus reward is to relate an investment to its valuation (i.e. is this investment a good deal relative to how good a deal the investment was at various points in the past or to its future prospects?). There are many ways to gauge value, but for simplicity’s sake, we will use the price-to-earnings (P/E) ratio. Simply stated, the P/E ratio relates the share price of a company to the earnings it generates. The higher the P/E ratio, the worse of a value it becomes and the lower the probability becomes that the subject company shares can perform in line with historical norms. This is a gross simplification of all the variables that go into the P/E and a rigorous company valuation, but the concept helps underscore a point. The only investors that undertake company valuation analysis are active investors….not passive index or smart beta investors. Therefore, if fewer and fewer investors are willing to undertake valuation assessments, then who is judging whether a company is overpriced or not? Clearly, it’s not the index/ETF contingent.
Ease of Trading ≠ Better Investment Outcomes
Just because you can trade an ETF (buy or sell) intraday, whenever you feel like it, doesn’t mean that this liquidity is a good attribute. In fact, Gratus (and others like Credit Suisse Global Strategist Michael Mauboussin) would argue that the more liquid an investment, the more likely it is that an investor will trade that investment. This is partly due to loss aversion, whereby losses that an investor experiences (whether realized or unrealized) feel three times worse than gains of an equal amount. Behavioral psychologists Daniel Kahneman and Amos Tversky documented this concept (known as prospect theory) in their academic paper.
Leaving loss aversion aside, buying a low cost index ETF does not guarantee a good investment outcome because the purchase of an ETF implicitly involves investment decisions to include what size companies to purchase (small v. large), where those companies should be domiciled (US v. international), type of company to be purchased (growth v. value), currency exposure, % weighting in the portfolio (overweight v .underweight), among others.
Next, there are instances of equity index /ETFs that actually trade at premiums to the companies within the index they are replicating. In this way, investing in these select ETFs means you are paying more than you would if you were to buy the underlying constituents. This is not supposed to happen in an ETF. Admittedly, this doesn’t happen very often, but when it does (as was the case with the Van Eck Junior Gold Miners) it makes news as the ETF marketing machines have placed considerable emphasis on minimal premiums and low cost.
Contrast the high-frequency trading of ETFs with some of the most successful investment programs, and we believe that the intra-day liquidity of ETFs is more of a marketing tool than an actual benefit to investors. In the case of Gratus, we prefer to hold our equity/ETF positions multiple years (if not decades).
Market Structure Degradation
I’ve left this section for last as it may be a little less intuitive than the sections above. I won’t go into too much detail here but wanted to show a chart that may shed some light on this section. Put simply, we now have a dynamic where an increasing number of ETFs are being created while the number of underlying stocks are declining. What new risks does this dynamic present?
Next, obtaining diversification within a portfolio of indices/ETFs is now harder to obtain. Take the case of ExxonMobil. It’s a mega-cap energy stock with ample amounts of trading liquidity in its shares and an above-market dividend yield (3.8%). Due to these qualities and the way these attributes are weighted in both market capitalization as well as factor-based indices, ExxonMobil finds its shares a top 10 holding in a surprising number of ETFs, to include iShares Core Dividend Growth ETF, iShares Russell 1000 Value ETF, PowerShares BuyWrite ETF, SPDR MSCI USA Quality Mix ETF, Goldman Sachs Active Beta US Large Cap Equity ETF, John Hancock Multifactor Large Cap ETF, SPDR S&P 1500 Momentum Tilt ETF. Does ExxonMobil really fit the requirements of all these types of investment vehicles? You can see the issue in trying to reduce overlap in an ETF portfolio where a single stock is held in many different indices. True diversification is harder to attain, which is why at Gratus we are migrating our portfolios to more active approaches.
Finally, within the context of market structure degradation, we will spend a little time on factor-based approaches to ETF/index construction. In the media, factor-based approaches are commonly referred to as “smart beta”. While the concept of smart beta is a valid approach to index construction (whereby stocks are selected not just by size but also other factors to include dividend yield, volatility, valuation, momentum) the problem lies with the mass adoption of the concept. I would note that most major investment firms, to include behemoths like Dimensional Fund Advisors (DFA), now have smart beta index ETFs as a product offering. Observing this build-up in enthusiasm, our thoughts turn to the risks: if we all agree that equities are trading at elevated valuation levels generally, then what good does weighing by slightly lower P/E or slightly higher dividend yield provide…… if everything is overvalued? This is where an active manager’s decision on what constitutes absolute value from the smart beta relative value becomes important. This distinction can be seen very clearly in periods approaching major turning points in the equity markets (e.g. 1929, 1970, 2001).
In summary, as we have outlined above, there are many reasons to be wary of the passive investment revolution. So how are we addressing this potential issue in our portfolios? First, by recognizing that index mutual funds and ETFs have advantages and disadvantages. This is a big first step because the financial media and marketing machines like Vanguard and Blackrock have powerful platforms to spread their message which usually revolves around the ideas that (1) there is nothing to fear with index investments and (2) cost is the only area where an investor should focus. This, of course, is way too short-sighted. As even Vanguard founder Jack Bogle would admit, there are limits as to how many market participants could engage in indexing.
The simple fact is, no one knows the exact percentage amount where passive ownership in equity indices becomes problematic. We would argue that the math of index investing indicates we are closer to this problem area than many realize. As an investment firm, and not a marketing firm, Gratus has no preference in favor of any investment vehicle. Our concern is to provide high quality investment counsel and identify the appropriate strategies to achieve specified goals and objectives with the least amount of risk. For many of the reasons listed above, Gratus has been migrating toward select active investments as we believe better opportunity lies ahead for active strategies with a discernable value proposition. In an era where price is seemingly becoming increasingly irrelevant, we at Gratus Capital remain committed to the concepts of a value-oriented approach, as we believe that value (or price consciousness) is one of the few time-tested investment strategies leading to long-term success.
 Investment Company Institute 2017 Factbook
 Prospect Theory: An Analysis of Decision Under Risk (1979).
 Horizon Kinetics, “Indexation: Capitalist Tool”, October 4, 2016
The above article is intended to provide generalized financial information; it does not give personalized tax, investment, legal, or other professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other matters that affect you or your business.