Active vs Passive Investing
The evolution in the asset management industry has picked up pace in recent years. A long term trend has been taking place in the industry, as index funds and ETFs have significantly increased their share of assets under management. Since their first appearance in the US in 1975 (index funds), and the mid 1990’s (ETFs), passive management is estimated to have grown to 40% of the stock market. We use both strategies here at Equitas and it is important to know the differences between the two.
Actively managed equity funds have been underperforming and losing market share, while index funds and ETFs have gained market share. This is causing a fundamental shift in how investors think about capital allocation, track risk adjusted returns, and the value added by the underlying managers. The classic strategy of active managers following Graham and Dodd methodology is to find companies whose intrinsic value is higher than the current market value, and wait for the rest of Wall Street to discover the hidden value and push up the stock price. The new environment causes problems with that strategy.
The environment for active money managers has been confusing and tough. For example, one of our money managers has been a large investor in the Liberty Companies (LVNTA), a group of companies controlled by John Malone. John has had a great track record of creating wealth for his investors. An article in Barron’s this year compared his results to Warren Buffett’s, and found that over the last 10 years, Malone’s companies have returned +13% per year vs. +7.5% for Buffett’s Berkshire Hathaway, and +7.7% for the S&P 500. For the most part, these businesses did very well, and the intrinsic value increased. However, the stocks did not reflect this growth in value and decreased. Let me give you the specifics.
As the following chart shows, for 2016 the tangible assets of Liberty increased $11 from $44.50 per share to $55.20 per share, a +24% increase. However, the stock dropped $2.60, from $45.11 to $42.50 or a ‐6% decrease (this is on a pre‐split basis for comparative purposes). The spread between intrinsic value and the price of the stock widened to 30%! A momentum investor might have sold the stock. A passive investor ignores intrinsic value and all other fundamentals. The fundamental value style manager held firm and the stock was up 18% in January 2017. They expect more appreciation to follow as investors recognize this value. The question is which investors will recognize the intrinsic value, and when will they act.
One of the reasons for a wide discrepancy between intrinsic value and stock price is the new fundamental effect of passive investing. As the chart below shows there has been a huge move of money going out of active managers and into passive vehicles like ETFs and index funds. The Liberty stock is not a part of any index, and is mostly owned by active managers. Both sides of this scenario are a negative for the stock.
What everyone seems to have forgotten is that the active/passive investing preference is cyclical. As the following chart shows, the index funds swing from the 20th to the 80th percentile in the universe of active money managers. A ranking of 20 means the index beat 80% of the active managers. A ranking of 80 means that 80% of the active managers beat the index.
We don’t know when, but the cycle should eventually come around, and active management will again prove its worth. With higher rates comes greater dispersion in the market (correlations are already coming down to levels we haven’t seen since 2007), which should be a good environment for active stock pickers. One of the consequences of the shift from active managers to passive vehicles is that because money flows tend to follow the direction of the market, the momentum of the swings takes the index to extremes past the valuation point in both directions.
The big question is whether this is good, or bad, for the remaining active managers. We could build a case either way. It could be bad if the managers do not assess the new fundamental factor of having 40% of the market now invested passively and affected solely by money flows. It could be good if the managers can assimilate the new fundamental of the passive investments and invest around this factor with offensive and defensive strategies.
Passive investing does not account for the fundamental values of any stock. No earnings, no growth projections, no PE ratios, no assessment of company management, stock price, nothing is relevant to the indiscriminate index buyer. In most cases, stocks are bought across the board regardless of price according to size of the company. This means that the only variable is money flowing into, or out of, the index funds, which creates a “risk on/risk off” behavior in the market. Behavioral Sciences will be an even more important fundamental to assess. This is pure human nature, which tends to follow a herd mentality and move past intrinsic value going up, and down. We believe this is a new fundamental to be considered for successful investing.
So does Ned Davis of Ned Davis Research who thinks we are in the late stages of a bubble in passive investing. “When one buys an S&P index fund, one buys all the stocks in the index – whether cheap or expensive,” Davis writes, “and today the price-to-sales ratio of the median stock has surpassed its level in 2000 and 2007.” But lately the correlation is fraying, a sign that “the trend toward passive investing is overextended.” Davis thinks the next five years will present great opportunity for active managers to outperform passive indexes.
Since 2007, macro-economic factors have driven correlation to historically high levels. Since the election, however, the correlation between the investment sectors has come way down and the sector dispersion has increased significantly as shown on the graph on the previous page. Active managers tend to outperform when dispersion of returns is high, and correlation of returns is low, hence an inefficient market.
This allows for unique insights gained from investment research to be beneficial in the investment process. Unfortunately for active managers, the 40% allocation to this new passive management style does not follow or react to fundamental stock research. A return to wide stock dispersion should be good for active equity managers and long/short managers that look to make money on both sides of the market. Active managers like to see a wide variance between winners and losers that they can capture for profit. We believe the environment may be in place for the pendulum to swing back, a return to the mean, with lower correlation, higher stock dispersion, and potential future performance for active managers.
In 2002, Equitas Capital Advisors, LLC was established as a unique company that blends the resources of a large global corporation with the flexibility of a small boutique firm. The registered service mark of Equitas Capital Advisors is Engineering Financial Solutions® and the purpose of Equitas is to design, build, and deliver investment solutions to meet the goals and objectives of our investors. Equitas Capital Advisors, LLC located in New Orleans, has over 200 years of combined investment management consulting experience providing professional investment management services to investors such as foundations, endowments, insurance companies, oil companies, universities, corporate retirement plans, and high net worth family offices.
Disclosures and Disclaimers:
Above information is for illustrative purposes only and has been obtained from reliable sources but no guarantee is made with regard to accuracy or completeness. It is not an offer to sell or solicitation to buy any security. The specific securities used are for illustrative purposes only and not a recommendation or solicitation to purchase or sell any individual security.
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Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the author on the date of publication and are subject to change. This publication does not involve the rendering of personalized investment advice.
Charts and references to returns do not represent the performance achieved by Equitas Capital Advisors, LLC, or any of its clients.
Asset allocation and diversification do not assure or guarantee better performance and cannot eliminate the risk of investment losses.
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