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Index funds lack checks on stocks they buy

Two years ago in Cuffelinks, I wrote an article entitled Index funds invest in the bad and the good, and said; “The blind buying of mountains of stocks simply because they are in an index will drive mispricing that active managers can rely on to outperform the same index. As more investors flock to the index, the argument trotted out that most active fund managers fail to beat the index will become less true, if not false. The hitherto reason for investing in the index will break down, just as active managers reward their investors with greater outperformance over the long run.”

I also added, “Index investing, in particular when it is directed to cap-weighted equity indices, is dumb investing. When Warren Buffett 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.”

Low interest rates have driven high prices

Since then, some infinitely smarter and more influential researchers have warned investors against index investing. In late 2016, Steven Bregman of Horizon Kinetics presented at the Grant’s Interest Rate Observer Conference a paper entitled, Indexation: Delivery Agent of The Great Bubble. He warned investors that their switching of trillions of dollars in the US from actively managed funds into index ETFs was driving them back towards the same idiosyncratic risk they were seeking to avoid by selecting passively managed index funds.

[A 40 minute video of Bregman’s presentation is linked here].

Bregman noted, as I have here and here at Cuffelinks, that the reluctance to hold cash has “very likely created balance sheet bubbles.” There is no doubt in my mind that the lowest interest rates since Captain Cook first crossed the Antarctic Circle have driven the record prices in everything from collectible cars and low digit number plates to wine, art and Brisbane apartments.

But in addition, many investors have simply given up on direct equities and even actively managed funds and opted instead for cheaper alternatives such as index ETFs. These index funds ignore the long-term drivers of returns, such as ‘value’ and ‘quality’ and buy all the stocks that make up the index the fund seeks to track.

Coincidently, the low interest rates and flat yield curves that have driven investors out of cash and up the risk curve have also reduced incentives for companies to invest for growth and incentivised the payment of dividends. Of course, high-dividend payout ratios mean low rates of reinvested profits, which translates to record high PE ratios coinciding with low growth.

Little or no earnings growth in largest companies

If Australia’s largest companies are paying the bulk of their earnings out as a dividend, the corollary is they expect little or no growth in earnings. Telstra’s earnings per share are little better now than in 2005 and the S&P/ASX200 is no higher today than it was on 16 February 2007 — 10 years ago.

The economics of Australia’s biggest listed companies will not turn significantly more positive in the next 10 years so why should the indices they contribute to produce returns any better? The S&P/ASX200 cap-weighted index fund is not constructed with long-term returns in mind. It merely reflects the trading activity in Australia’s largest 200 companies.

But what if inflows into index ETFs stop flowing in and start flowing out? This is the question Bregman asked in October last year.

The business of ETFs looks good when funds are flowing in. Bregman noted there were 204 ETFs in the US in 2005 but by 2015 there were 1,594. In Australia, there are 179 ETFs. Low fees are one of the carrots used to attract investors to index investing. The other one is selective time frame comparisons of returns. It is true that many actively-managed funds underperformed the index in 2016, but over five years and since inception, many active managers in Australia beat the S&P/ASX200.

Focus on big stocks

The large ETFs tend to concentrate their activity among the big stocks. In the US, this has produced some curiosities. For example, Bregman notes ExxonMobil is “25% of the iShares US Energy ETF, 22% of the Vanguard Energy ETF, and so forth, [but] ExxonMobil is simultaneously a dividend-growth stock and a deep-value stock. It is in the US quality-factor ETF and in the weak-dollar US equity ETF. Get this: It’s both a momentum-tilt stock and a low-volatility stock. It sounds like a vaudeville act.”

This might not seem significant to an Australian investor, but in the past three years, the oil price is down 50%, ExxonMobil’s revenue is down 46%, its earnings per share is down 74%, the dividend-payout ratio is almost 3x earnings and total debt up 129%. Yet the stock was up 4% from the second quarter of 2013 to the second quarter of 2016. Bregman called it “an exercise in levitation” thanks to the distortion of prices by index investing buying.

In Australia, despite, or perhaps because of, our relatively smaller size, the iShares Edge MSCI Australia Minimum Volatility ETF, the Russell Investors Australian Responsible Investing ETF, the Russell Investors High Dividend Australian Shares ETF, the Russell Investors Australian Value ETF and the UBS IQ MSCI Australia Ethical ETF all have Telstra and the big four banks in their top 10 or 15 holdings. Indeed, all the above ETFs held CBA and WBC as their top two holdings and the big four banks as their top four holdings.

The scaling requirement has produced other curiosities in Australia. Funds that label themselves ethical or responsible hold Rio, BHP, Woolworths, and Woodside.

Bregman notes that in the US, the annual share turnover of ExxonMobil is 90% and IBM Corp 128% but the turnover of the SPDR S&P500 ETF was 3,507% or 100% per day! In other words, the average holding period is just one week. What do you think might happen to share prices if ETF inflows turn into outflows given turnover of an ETF is dozens of times higher than that of the underlying securities? On 24 August 2015, Bregman observed a dress rehearsal of what might transpire. On that day, the price of the iShares Select Dividend ETF fell 35% while the NAV dropped just 2.5%.

Could it be that the idiosyncratic risk investors sought to diversify away from by investing in index funds is the same risk they are unwittingly heading headlong into, while the indexes are fully invested and shares are at record price to earnings multiples?

Author of 1955 bestseller The Great Crash, John Kenneth Galbraith, explained the cyclical instability inherent in modern capitalism as stemming from the accumulation of excessive wealth and the fragile nature of the financial system. Galbraith noted, all stockmarket bubbles exhibit "seemingly imaginative, currently lucrative, and eventually disastrous innovation in financial structures". Bregman suggests the current fascination with index ETFs in the US will not end well.


Roger Montgomery is Chairman and Chief Investment Officer at Montgomery Investment Management. This article is for general information only and does not consider the circumstances of any individual.

May 13, 2017

Having lost time ,opportunity and capital investing in stocks recommended by financial planners , investment and retail super funds .I now do it myself with fairresults. At least I have stopped losing money.Companies seem to be run by people who spend most of their time organizing to increase their pay and options increases .
In retrospect I think the two best ways to make money is through buying Sydney real estate on a train line and keeping it. The yield goes up and up as rents increase.
The other way is to run your own business and plow profits into real estate. .
I would forget stocks if you are young enough to own real estate for 30 or 40 years.

Graham Hand
May 12, 2017

Jared Dillion of Mauldin Economics (in his newsletter this week) supports some of the points made by Roger in being a professional fund manager and perceiving a problem before the market does. It might mean a period of so-called underperformance until the market takes the same view.

"There are a lot of people who say that you can’t predict bear markets, so you might as well just ride them out and dollar cost average. Also true—for most people. If you drill teeth for a living, you probably don’t have any business trying to time market cycles. Perhaps you rely on me for that. Better than nothing.

But it is true that if your time horizon is basically infinite (retirement 40 years away), it doesn’t make a lot of sense to try to avoid a 20% speed bump.

If you’re a professional investor, then you care very much about avoiding (or capitalizing on) bear markets. Problem is, the timing is still impossible.

“Professional” investors have been buying cheap stocks and selling expensive ones for the last four years, and they keep getting carried out, because nobody has that kind of staying power. You might be right in 2017, but if you were early in 2013, it doesn’t really matter.

All of investing is a push/pull between being early and being right. Smart guys are always early. Very smart guys are always very early. The smartest guys can see stuff years in advance. And their returns are often the lowest, because they shoot before the squad is ready.

Silly example: Amazon has been a joke since 2012. Unless you think it will someday raise prices, it doesn’t matter if it is the biggest company in the world, it is still a zero. Finance 101, discounting cash flows. The nature of markets is that sometimes markets care about cash flows in the future, and sometimes markets care about cash flows today.

Do you remember 2001-2002, during the dot-com bust? If the stock in question didn’t have real earnings and pay a real dividend, it was taken out with the trash. And that will happen again."

Ramon Vasquez
May 12, 2017

Hello Everyone .....
For chartists, it matters not very much one jot whether or not an index comprises of some weak stocks because one would enter and exit based upon one's particular charting rules alone without consideration for a value-based determinant.
But then, not every one is a chartist; so the problem remains for most investors.
Good luck. Ramon.
P.S. I have recently been converted to a value - ridden approach after having read Roger Montgomery's book "".

Steve Martin
May 11, 2017

Roger's comments here and previously have always made perfect sense to me. Yet, my portfolio is dripping red from active fund managers carefully chosen for their past performance, and strong reputation, but as soon as I hitched my wagon to their star, they have underperformed and in some cases lost money in a rising market. The reasons given are poor stock selection and getting the market timing wrong. I have demonstrated that I could do that as easily by myself and now I am doing it with fund managers. I think I am starting to learn that while indexes must contain some long standing underperforming stocks, they also include some indeterminate stocks which will surprise on the upside.

There is scope for someone wittier than me to adapt the Harvard Law of Microbiology to stock selection viz "Under the most rigorously controlled conditions of pressure, temperature, volume, humidity, and other variables, the organism will do as it damn well pleases."

Alex Vynokur
May 11, 2017

Thanks Roger for the contribution.

For the record, the above comment from [Alex] is not mine.

The growth in ETFs globally is hardly the cause of problems for active managers, it is merely one of the symptoms.

The trend towards lower cost and more transparent index/smart beta investing should be hardly surprising if we pay attention to the cold hard facts that majority of active funds cannot outperform the index after fees. In all sorts of market conditions.

I think it is not right to describe index investing as dumb. If it’s dumb, it should be so easy to outperform. Except that it's not for most active managers - less than one-quarter of Australian and International equity funds outperformed their relevant index benchmarks in 2016 net of fees.
Full details including similar stats for other years here:

I also think we are missing the point by showing examples of different ETFs that own the Big 4 banks or Telstra. Have we done a count as to how many active managers are in the same stocks? I’ve had a good look and would encourage others to do the same!

Don’t get me wrong -- I am not for a second suggesting that index is good and active is bad. I believe that active investing can and should co-exist with index/passive investing. They both have a role in a client’s portfolio.

There are many fantastic managers that offer truly active, true to label asset management for their clients. They will always thrive, and will not be threatened by index funds. Many have strongly aligned business models and fee structures which fairly distribute risk and reward. However, index hugging funds that underperform and charge high fees for the pleasure should indeed be concerned. If you had an airline where planes were late 75% of the time, fares were high and safety record was average, it probably wouldn’t stay in business for too long. In funds management, given the historical distribution model with associated ‘incentives’, too many people stayed in business and thrived while failing to deliver for their clients. This could not be sustained in most other industries and it will not be sustained in funds management.

As the ETF industry grows, it is good to see the hard questions asked and scrutiny applied. ETF and index investing continues to evolve, but growth and innovation needs to be responsible. Some of the developments in the US (e.g. 4x leverage products with daily reset) remind that vigilance is necessary in order to avoid disappointing outcomes in the future.

Funds management industry (both active and index) will continue to evolve in order to deliver for investors and prosper long term. It is not the first industry to go through changes, and it sure isn’t the last.

Exciting times ahead!

May 11, 2017

the article starts "Two years ago in Cuffelinks, I wrote an article entitled Index funds invest in the bad and the good, and said; “The blind buying of mountains of stocks simply because they are in an index will drive mispricing that active managers can rely on to outperform the same index. "

Two years later and the writer has underperformed the index in that time. Perhaps some facts wouldn't go astray.

Roger Montgomery
May 11, 2017

Peter, The Montgomery Private Fund has in point of fact outperformed over two years to April 30 2017. It has generated a return of 5.94% versus 5.84% for the broad market as represented by the ASX300. The Montgomery Fund has slightly underperformed. In both cases a very high cash weighting - capital protection - has been in place so the invested portfolio has dramatically outperformed.

The sentence you quote says "The blind buying of mountains of stocks simply because they are in an index will drive mispricing that active managers can rely on to outperform the same index.” At some point the misplacing will produce anomalies that can indeed be relied upon. That appears to now be happening and is reflected in strong outperformance of the Montgomery Funds since Dec. 31, but time will tell.

That aside, the argument that there is a very high level of idiosyncratic risk in ETF is well made and unchanged by your comment. It is also worth noting that the following global and US funds (many of whom have multi-decade histories of outperformance) have underperformed over the last two years: Fairholme, Wintergreen, Longleaf Partners, Berkshire Hathaway, Pershing Squared, Ichan Enterprises, Greenlight Reinsurance, Royce Micro-Corp. Should we conclude that that they have all “lost their touch”? or was the S&P500 the “anomaly”? The frequent comment that active underperforms passive is simplistic and perhaps in a future article we can address the issues and what an investor in active funds should be looking for. Thank you for the vigorous debate.

Jerome Lander
May 11, 2017

Many investment vehicles simply reflect investment fads.
Investors need to avoid "crowded trades" if they are to protect their capital, even if it comes at the cost of short-term under performance.
Investors should look for reasonable fee genuinely actively managed product that is genuinely aligned to their needs. A good adviser and strong technical help can help tremendously with this.
Nothing can replace the rewards and superior risk management that comes with skilled help and hard work.

May 11, 2017

I read a report the other day that said there were 1,400 active ETFs on NYSE. The original big old ETFs probably still hold much of the cash but the vast majority of ETFs by number are active bets. eg none of Betashares ETFs are traditional passive – they are fairly narrow active bets. The growth of ETFs in Australia and globally has been driven by investor dissatisfaction with active funds and their high fees.


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