Active versus passive when prices are extremely stretched

Roger Montgomery

Montgomery Investment Management

There’s a pithy marketing one-liner that has almost single-handedly produced a multi-billion dollar index-fund and ETF industry. It goes something like this; ‘Most active fund managers underperform the index.’

We can explore whether that is actually true in a moment, but I would like to offer an alternative one-liner; ‘The ASX/S&P200 has gone nowhere in a decade; why invest in the index?’ or another perhaps less pithy one-liner; “so much money has poured blindly into index funds that the underlying stocks are now mispriced, and cautious active investors – those with an eye to quality and value – will better protect investors funds.”

As passive index investing becomes ever more popular, the arguments that justify the switch from ‘active’ to ‘passive’ management weaken and then completely break down.

Most dangerously, as index investing grows in popularity so too does the divergence between stock prices and fundamental values. Retail investors are none the wiser, and simply trust those recommending the lazy and cheaper index-fund approach.

Strong market performance is having a positive impact on index investing’s popularity. The adoption rate can reasonably be expected to be highest when the market is at a crest and lowest when the market is on its knees – precisely the opposite of a successful investment strategy.

The promise of diversification, low cost and access to overseas markets are the top three reasons for the popularity of index funds and ETFs – but index investing, when it is directed to cap-weighted equity indices, is simply ‘dumb’ investing. In fact, this point was made by Warren Buffett when he recommended index investing to the masses; he made the point that it suits the “know-nothing investor,” — that is, the investor who has no interest in understanding a business or valuing it.

There are several reasons to be cautious on index investing, irrespective of whether that is through an unlisted fund structure or through an exchange-traded fund. You’ll notice that the S&P/ASX200 index today is lower than a decade ago. There is a very good reason for this; most of the index is weighted to large, mature companies that pay most of their earnings out as a dividend, leaving very little for growth.

High pay-out ratios mean investors get a yield but not much else. This is a serious problem if you want to maintain your purchasing power, as being able to afford rising utility, healthcare and entertainment expenses, requires growth in both your wealth and income.

By way of example, Telstra’s share price today, and its dividend in 2018, is barely higher than almost two decades earlier in 1999, but I bet your cost of living is more today, than in 1999.

As Ben Graham once wisely observed, in the short-run the market is a voting machine, but in the long-run it is a weighing machine. If the underlying companies cannot grow their earnings because of high pay-out ratios, neither can the index based on them. So the weak performance of the ASX/S&P200 index will lock investors into mediocrity.

Returning to the question of active managers underperforming the index, it is very true that the US index, as measured by the S&P500, has performed very well. It is also true however that 30 per cent of its gain this year can be attributed to funds flowing into just five companies; Amazon, Google, Microsoft, Apple and Facebook. Additionally, much of the funds flowing into these five companies have been via exchange-traded funds, the biggest of which is Morningstar’s SPDR S&P500 ETF whose top 10 holdings includes all the above-mentioned stocks.

A lot of investors’ futures are being held up by the profit outlooks for these five companies. Active managers are measured on a variety of factors including volatility, for which one measure is the Sharpe Ratio. If a fund delivers a 10 per cent return with 10 per cent volatility, the Sharpe Ratio is said to be 1. A Sharpe Ratio above 1 is exceptional. Since 1928 the S&P500 index Sharpe Ratio has been 0.4, but for calendar 2017, year to date, the Sharpe Ratio is on track to be 3.5. If index investors think this is normal, watch out.

Of course, as I write this, everything looks benign and nobody can see any risks, which is precisely why no risks are being priced in. When the market is rising, index investing looks sensible, but what happens when the index declines and investors want their money out and their ETF’s have bets concentrated in a narrow band of tech stocks?

While exchange-traded and index funds have been heralded as one of the most important financial innovations during the last decade, promoters fail to warn investors of their limitations and risks. Active fund managers, especially those who put the protection of capital above the last few percentage points of gain, are currently losing to the optimists and the index. Active managers, however, are focused on quality and value, and protecting capital, something that always wins in the long run.

Roger Montgomery
Founder and Chairman
Montgomery Investment Management

Roger Montgomery founded Montgomery Investment Management in 2010. Roger has more than three decades of experience in investing, financial markets and analysis. Roger also authored the best-selling investment book,

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