Have We Reached Peak Index?
Written by John Parsons
Last month the Investment Management Consultant’s Association (IMCA) held its Annual Conference Experience at the San Diego Convention Center. I’ve been attending IMCA’s conferences for the last 15 years, and have seen the organization and event grow in size and scope over the years. They have consistently provided timely information and thoughtful speakers who deliver exceptional insight and commentary as part of the conference program. Each year provides an interesting mix of topics, but definite themes emerge that touch on the hot topics of the day. In prior years it may have been emerging markets or tactical asset allocation. Hedge funds were in heavy rotation not long ago, and last year it was alternative investments and navigating the low interest rate environment. This year it was ETFs and the rise of smart beta.
It’s no surprise that passive investment opportunities garnered much focus this time around. Market-weighted indices have been on a tear of late, and as far as the media is concerned it seems the end times for active investment management is fast approaching. Not long ago, The Wall Street Journal ran a series of articles “exploring the rise of passive investing” titled “The Passivists.” Pieces ran with titles such as “The Dying Business of Picking Stocks” that essentially laid out empirical evidence suggesting the days of active management were indeed certainly numbered. Investment firm marketing departments have also grabbed hold of the trend and have manufactured products, and run print and television commercials touting the latest opportunity for the investing public to ride the wave to newfound riches.
Some interesting takeaways from the conference included a session by Tobias Moskowitz from Yale School of Management, who provided historical insight on style premia – the basis for today’s “smart beta” products. He highlighted the economic conditions under which each factor, or combination of factors, has performed favorably, and whether it is possible to improve your factor timing ability. He found that the evidence on timing success is very weak. He tried like crazy through back-testing to find meaningful indicators, but couldn’t – even with a century’s worth of data. Buy and hold strategies consistently outperformed trading – before considering costs. He concluded that the benefits of the strategy were the diversification effects. Nevertheless, there is a need to fully understand what these different smart beta strategies are doing, so you don’t get blindsided by underperformance when the markets turn against you.
Michael Gallmeyer, PhD, from the McIntire School of Business, University of Virginia, walked through the evolution in investment products. He concluded that factor-based investing is far more art than science. To even begin to be successful one must understand factor estimated returns, which is no simple task. It’s much easier to predict volatility or risk than ever to estimate returns in the short term.
Jim O’Shaughnessy, CEO and CIO of O’Shaughnessy Asset Management, seemed to be the lone advocate for active management in a conference that was largely focused on passive investment ideas and provided some arguments in defense of his firm’s active efforts. He asserted that active management was, in fact, not dead, but that investors are only suffering from “recency bias” – where they focus on things that have happened recently and assume they will continue into the future. For example, market surveys showed the highest bullishness in winter 2000 and worst bearishness in February 2009. In hindsight, we know those were right at the moment of those markets’ respective inflection points. He also pointed out that the market-cap weighed structure of the indices can be problematic. They, and their associated ETFs, can in effect become momentum funds at exactly the wrong time. The largest weighted stocks can also often become the most expensive index constituents. His argument was that market cap weightings can lead you to a place you don’t necessarily want to be. He determined that smart beta portfolios are better than a market index, but not significantly so. He also presented a couple alternative index structures, including weighting index constituents by sales. However, that proved to be not much different from the outcomes from market cap weighting. Conversely, an equal weighing scheme would give smaller companies a fair chance to contribute. But, ultimately, he concluded that stock valuations mattered most. To quote Warren Buffet, “Price is what you pay, value is what you get.” Over time, value-weighted portfolios – those with the cheapest price-to-sales – were shown to greatly outperform. If you pay less for something to get more, O’Shaughnessy says you’ll do all right in the long run. That’s where active management with a consistent strategy will show its worth, but one must be willing to stick with it. He lamented that investors have lost sight of why they went with active management in the first place.
Both Moskowitz and O’Shannessy had compelling slides charting the fairly consistent patterns of the ebbs and flows of how active management has performed relative to passive over time. Looking at the percentage of funds outperforming the market on a 5-year rolling basis strongly suggests that we are at a bottom of a trough this year, with less than 10% of active managers outperforming the market – a decline from the most recent top of over 60% in 2010. The last time the comparison dropped under 10% was in the period between 1998 and 2000. If the historical patterns play out similarly we might be nearing a period of improved relative performance for active management.
I’m not ready to accept that professional money managers have lost their ability to pick winning investments all at the same time. We’ve seen this before. Value investing was considered dead at the height of the tech bubble in the late 1990s, only to come roaring back a couple years later. Likewise, large cap managers who shunned Microsoft’s lofty valuations had difficulty keeping pace with the S&P 500 in the short-term when the stock’s prominence drove the index ever higher. It’s possible we could be passing through a similar period when investor demand for products linked to passive benchmarks is driving indiscriminant buying of stocks regardless of their valuation or underlying business strength simply because it is an index constituent.
I agree that the last couple of years, or so, has seen a period where the markets at various times have favored high-valuation, high-growth companies, or beaten-down stocks of companies with questionable earnings outlooks. There have also been periods of narrow market participation with very concentrated leadership that saw lower-quality companies with high betas, high price-to-earnings, high debt-to-capital, and low ROE outperform. Many active managers don’t see those stocks as good values, and it would be unlikely for them to be held in portfolios. The majority of active managers on our platform tend to adhere to consistent investment theme – higher-quality companies selling at relatively attractive prices.
It’s safe to say that when the markets broaden, maybe soon, active management will again have its day. It will then be interesting to see how committed to their passive products investors really are, and to what extend flows reverse themselves and stock picking once again comes in vogue. Investors are a fickle bunch.
This blog post was written by John Parsons, CIMA®, Senior Research Analyst.