Tag Archives: opinion

Why Hasn’t Active Investing Outperformed Passive Investing In Recent Years?

By Jason Voss, CFA Over the last several months, I’ve explored why active investing has been unable to outperform passive investing in recent years. My series is called Alpha Wounds, and so far, the issues covered are the unintended consequences of benchmarks on active management, the poor measurement techniques of investment industry adjuncts, and the lack of diversity in the human resources portfolio . In this week’s CFA Institute Financial NewsBrief , we decided to ask our readers their explanation for the lack of active management outperformance. Rare for our polls, we included a large number of options to try and capture a wide swathe of opinions. The options provided appear to have successfully reflected the broad range of views, as 90% of the 743 respondents selected one of the specific choices rather than “other”. Because it is difficult to know the precise reason for choosing the “other” category, it makes sense to recalculate the percentages without including “other”. These modified results are the ones listed in parentheses below. Note: We did receive one e-mailed response from a reader who opted for “other”. The reader explained, “I marked ‘other’ [because] the market is illogical, so trying to apply logic is bound to fail.” Why has active investing been unable to outperform passive investing in recent years? (click to enlarge) Active Managers Can Do Nothing to Outperform About 24% (27%) of respondents believe that the reason for active management’s underperformance is the deleterious effects of high fees on net performance . This is not surprising, given the large number of studies highlighting this fact. Many asset management firms are, in fact, trying to reduce their expenses to mitigate this alpha drag. Another 15% (16.5%) believe that individual investment managers cannot compete with the wisdom of financial markets. Combined, this means that about 40% (43.5%) believe that no matter what active managers do, they cannot beat passive investment strategies. Active Managers Can Do Something to Outperform Of the remaining five options, 10% (10.8%) believe that the concentration of top stocks in indices detracts from the success of active managers. For those not familiar with the argument, it recognizes that indices have built in momentum effects because many of them are market capitalization-weighted. Indices are, effectively, “must buy” lists of securities that create demand, not because of fundamentals, but because passive strategists must buy the securities in order to closely track their index. Controlling for these momentum effects is outside the specific capabilities of active managers as security prices advance. When indices fall, however, active managers not invested intimately with the securities in the index should be able to avoid some of the downside. What hope do active managers have of beating passive strategies? Together, the four remaining options provide some insight. Most importantly, according to 18% (20.2%) of respondents, active managers should minimize their use of benchmarking, style boxes, and tracking error, which lead to a sameness of results. Next, 13% (14.7%) believe that active managers are guilty of short-termism and need to change their investment time horizon and lower turnover. Incidentally, lowering turnover reduces trading costs and will reduce the expense ratio of active funds. Increasing diversity of opinion in active management is believed by about one in 20 respondents (5.5%) to be critical for improving success. Lastly, approximately 5% (5.2%) of those polled think that active managers should improve their due diligence to better compete with passive strategies. Active vs. Passive Tug-of-War Taken together, the above four tactics, all well within the purview of active management, represent about 46% of total responses as compared with the roughly 44% of responses from those who believe active strategies can never beat passive ones. This result indicates a tug-of-war between camps and, to my mind, reflects the conversation occurring in the financial community in the long-running active vs. passive debate. Disclaimer: All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

FSTA: This Little Gem Of An ETF Is Beautiful When You Look Inside

Summary FSTA tracks one of my favorite sectors and there is nothing to hold against it. From the market capitalizations of the companies down to the top 10 holdings, everything looks intelligently designed. While many consumer staples ETFs would be scared to go overboard on tobacco, FSTA gets it. Consumer Staples funds should be loaded up on companies producing addictive products. I’m a little concerned about the sheer size of the allocations to Coca-Cola and Pepsi because of a movement towards healthier foods. I wouldn’t want to cut out those holdings because I think the distribution and branding systems give them moats for competing in healthy foods. One of the sectors I’ve come to like is the consumer staples sector. Unfortunately, many investors seem to be catching on to how desirable the sector allocation is when there are concerns of a new correction or recession. One of the funds that I’m considering is the Fidelity MSCI Consumer Staples Index ETF (NYSEARCA: FSTA ). I’ll be performing a substantial portion of my analysis along the lines of modern portfolio theory, so my goal is to find ways to minimize costs while achieving diversification to reduce my risk level. Expense Ratio The expense ratio on the Fidelity MSCI Consumer Staples Index ETF is only .12%. This fund gets my stamp of approval for giving investors consumer staples exposure at a very reasonable expense ratio. Market Cap The ETF has a focus on large capitalization companies, but investors should be worried if this chart looked different. The idea is to load up the portfolio on big companies that are designed to withstand negative events in the economy. I think large companies make more sense than smaller companies in that aspect because I want to see companies that are market leaders with strong pricing power in an established industry. Geography There really isn’t much to talk about here. This is all domestic equity. Sector This sector breakdown is excellent. Personally, I have a moral objection to companies that sell tobacco products because they cause cancer. On the other hand, I don’t have a moral objection to risk adjusted returns. The result of that conflict is that I have to admire the structure of this portfolio. I’d love to see a further breakdown in some categories such as beverages because I’d value having some alcohol in the portfolio as well. When I’m looking at consumer staples, I want companies that sell products that are absolutely addictive. This is just cold hard logic. Market leaders that can dictate pricing on addictive products are in the ideal position to survive recessions without a major drop in sales or earnings. Largest Holdings This is a solid batch of holdings. I don’t see a single company on the list that looks exposed to a recession. I’ll admit that having both Coca-Cola (NYSE: KO ) and Pepsi (NYSE: PEP ) at the top of the portfolio feels a little heavy. If I was going to tweak the portfolio a little, I might drop those two in favor of having a little more alcohol. My big concern about those companies is that I believe we are in a very long term shift towards healthier food and some of their branding value is going to be lost. The reason I would still want a significant allocation is because they are both masters of building brands and have established enormous distribution networks across the world. When (or if) that sustained shift to healthier foods does occur, I expect both Pepsi and Coke to be in position to buy up smaller companies with the right products and then run the products through their branding and distribution product. Simply put, even if they don’t have the right products yet, they have incredible economic moats that should help them acquire the right products and utilize those products better than smaller competitors could. As I’ve been going through consumer staples ETFs, I’ve noticed that Wal-Mart (NYSE: WMT ) is suspiciously absent from some of them. I think that is a mistake. I really like Wal-Mart as a dividend growth company and I think the employee wage issues are overblown . Building the Portfolio The sample portfolio I ran for this assessment is one that came out feeling a bit awkward. I’ve had some requests to include biotechnology ETFs and I decided it would be wise to also include in the related field of health care for a comparison. Since I wanted to create quite a bit of diversification, I put in 9 ETFs plus the S&P 500. The resulting portfolio is one that I think turned out to be too risky for most investors and certainly too risky for older investors. Despite that weakness, I opted to go with highlighting these ETFs in this manner because I think it is useful to show investors what it looks like when the allocations result in a suboptimal allocation. The weightings for each ETF in the portfolio are a simple 10% which results in 20% of the portfolio going to the combined Health Care and Biotechnology sectors. Outside of that we have one spot each for REITs, high yield bonds, TIPS, emerging market consumer staples, domestic consumer staples, foreign large capitalization firms, and long term bonds. The first thing I want to point out about these allocations are that for any older investor, running only 30% in bonds with 10% of that being high yield bonds is putting yourself in a fairly dangerous position. I will be highlighting the individual ETFs, but I would not endorse this portfolio as a whole. The portfolio assumes frequent rebalancing which would be a problem for short term trading outside of tax advantaged accounts unless the investor was going to rebalance by adding to their positions on a regular basis and allocating the majority of the capital towards whichever portions of the portfolio had been underperforming recently. Because a substantial portion of the yield from this portfolio comes from REITs and interest, I would favor this portfolio as a tax exempt strategy even if the investor was frequently rebalancing by adding new capital. The portfolio allocations can be seen below along with the dividend yields from each investment. Name Ticker Portfolio Weight Yield SPDR S&P 500 Trust ETF SPY 10.00% 2.11% Health Care Select Sect SPDR ETF XLV 10.00% 1.40% SPDR Biotech ETF XBI 10.00% 1.54% iShares U.S. Real Estate ETF IYR 10.00% 3.83% PowerShares Fundamental High Yield Corporate Bond Portfolio ETF PHB 10.00% 4.51% FlexShares iBoxx 3-Year Target Duration TIPS Index ETF TDTT 10.00% 0.16% EGShares Emerging Markets Consumer ETF ECON 10.00% 1.34% Fidelity MSCI Consumer Staples Index ETF FSTA 10.00% 2.99% iShares MSCI EAFE ETF EFA 10.00% 2.89% Vanguard Long-Term Bond ETF BLV 10.00% 4.02% Portfolio 100.00% 2.48% The next chart shows the annualized volatility and beta of the portfolio since October of 2013. (click to enlarge) Risk Contribution The risk contribution category demonstrates the amount of the portfolio’s volatility that can be attributed to that position. You can see immediately since this is a simple “equal weight” portfolio that XBI is by far the most risky ETF from the perspective of what it does to the portfolio’s volatility. You can also see that BLV has a negative total risk impact on the portfolio. When you see negative risk contributions in this kind of assessment it generally means that there will be significantly negative correlations with other asset classes in the portfolio. The position in TDTT is also unique for having a risk contribution of almost nothing. Unfortunately, it also provides a weak yield and weak return with little opportunity for that to change unless yields on TIPS improve substantially. If that happened, it would create a significant loss before the position would start generating meaningful levels of income. A quick rundown of the portfolio I put together the following chart that really simplifies the role of each investment: Name Ticker Role in Portfolio SPDR S&P 500 Trust ETF SPY Core of Portfolio Health Care Select Sect SPDR ETF XLV Hedge Risk of Higher Costs SPDR Biotech ETF XBI Increase Expected Return iShares U.S. Real Estate ETF IYR Diversify Domestic Risk PowerShares Fundamental High Yield Corporate Bond Portfolio ETF PHB Strong Yields on Bond Investments FlexShares iBoxx 3-Year Target Duration TIPS Index ETF TDTT Very Low Volatility EGShares Emerging Markets Consumer ETF ECON Enhance Foreign Exposure Fidelity MSCI Consumer Staples Index ETF FSTA Reduce Portfolio Risk iShares MSCI EAFE ETF EFA Enhance Foreign Exposure Vanguard Long-Term Bond ETF BLV Negative Correlation, Strong Yield Correlation The chart below shows the correlation of each ETF with each other ETF in the portfolio. Blue boxes indicate positive correlations and tan box indicate negative correlations. Generally speaking lower levels of correlation are highly desirable and high levels of correlation substantially reduce the benefits from diversification. (click to enlarge) Conclusion FSTA has a great expense ratio, great sector, and great allocations within the sector. This ETF is a slam dunk for long term holdings. The only concern I have about the sector right now is that other investors have caught on and started bidding up the price. There is one other worrying factor for the ETF. The average volume on it is quite dreadful. There are two ways to look at that issue. One is to bemoan the weak trading volume increasing the bid-ask spread. The other option is to look for ways to trade the ETF without commissions and then to keep using limit orders to try to enter at an attractive price. The ETF has far more liquidity problems than the underlying securities and the low expense ratio is fairly attractive for investors looking for a long term holding. The biggest caution here is that investors should avoid using any “market” orders. Only trade this one with limit orders.

Stocks Are Cheaper Than Bonds, And Other Falsehoods

Summary Currently, the crowd continues to advance the notion that stocks are the only investment to be considered, despite the overvalued condition in risk assets. The notion that bonds are overvalued and underperform stocks, and that cash is earning 0% is also advanced by the crowd. In reality, cash and bonds offer investors tremendous value in a world of declining economic growth. This is especially true given that the economic risks are rising. Stock Market Valuations within the Context of Global Economic Instability: Implications for Portfolio Construction Stocks are cheaper than bonds, or so we are told by the crowd which was out in full force again for the September FOMC meeting, calling for a rise in interest rates, despite the fact that we have not met any of the conditions for such a rise in rates. One of the major reasons investors, and more specifically savers, have for why the Fed should raise interest rates is the notion that cash is currently earning close to 0% on savings, and money market balances. However, when viewed within the context of the global economic environment, and when we take into account the impact of a rising dollar on purchasing power, cash is providing investors with a very nice return. In a previous piece , I explored the reasons behind holding cash. As risk asset prices have risen to lofty levels, investors are far better, in my opinion, holding a majority of their assets in Zero Coupon U.S. Treasury Bonds and cash. The Global Economy and the Rise of Deflationary Forces Why would I pursue a strategy of largely abandoning risk assets for fixed income and cash? For several reasons: 1. CAPE valuation The first reason is valuations. Valuations in the US are trading at levels that are more than 53% above its arithmetic mean and 65% above its geometric mean, as seen in the charts below. As the earnings season begins, the street is expecting a 4.6% decline in S&P earnings. I would contend that this is far more modest than what the actual numbers will turn out to be. The strong dollar continues to be a headwind, as is the decline in overall demand. This, combined with the complete decimation of the commodities complex , declining fundamentals in the global economy, and a FED that keeps the markets uncertain will likely lead to a severe drawdown in risk assets. In such an environment, cash and Zero Coupon U.S. Treasury Bonds are excellent investments. (click to enlarge) (click to enlarge) 2. The Real Yield on Cash The U.S. dollar has been rallying in the face of rising deflationary forces globally. Over the past three years, the U.S. dollar has soared 14.6%. I expect further economic weakness, and growing challenges overseas, combined with extraordinary monetary policy from the BOJ and the ECB will drive the US dollar higher relative to the yen and euro as well as other foreign currencies. As the value of the dollar rises, so does the buying power of Americans cash balances, making the real yield on cash much higher than the current minimal rate of interest. 3. Deflationary Forces and Tepid Economic Growth The challenges overseas are well documented. Japan remains in an economic malaise, even as Abenomics attempts to bring it out of the doldrums. The eurozone remains entrenched in an extremely slow-growing economic environment on the verge of recession, with deflationary forces rising. Canada is currently in recession, and in the United States, many try to make the case that the economy is doing just fine. But the reality is that the economy is a patient in need of ICU classification, as the charts below will indicate. The labor force participation rate is at its lowest level since 1978. (click to enlarge) To those who believe this is largely caused by the retirement of the Baby Boomer generation, the next chart will be particularly useful in dispelling this idea. (click to enlarge) Falling industrial production and ISM Manufacturing (below) are not indicative of an economy running on all cylinders. (click to enlarge) (click to enlarge) (click to enlarge) (click to enlarge) The data point that I find most concerning is the complete collapse in velocity to the lowest levels in more than 50 years. Despite the Fed’s massive QE program, velocity has continued to decline. (click to enlarge) Implications for Portfolio Construction The world is currently on the verge of a recession . Conventional investment planning has largely failed to protect client assets multiple times in the 21st century, largely due to its reliance on risk assets for the majority of client capital. I believe in a more conservative approach that protects investor capital through a complete investment cycle. On February 18, 2013, Dr. John Hussman wrote an excellent commentary entitled ” The Sirens Song of the Unfinished Half-Cycle ,” in which he explains the overvaluation of the market and the likely drawdown that will result in the completion of this market cycle. (click to enlarge) Since Dr. Hussman wrote this commentary, valuations have only extended further, making the current conditions all the more unstable. These are not conditions in which I would, in good conscience, be overweight risk assets. Especially that which is needed for retirement, regardless of age. I believe capital preservation is the key objective, and I am willing to miss excess gains on the upside when the market gets expensive, rather than be exposed to a severe drawdown due to speculation in an overvalued market. As we seek to preserve capital, cash and cash equivalents (Treasuries) appear to be the best investment vehicles in a world of slow economic growth with rising deflationary and recessionary risks and overvaluations on risk assets that make future returns minimal. While the equity risk premium has already been debunked , the future will likely give us a further case study. One thing I have learned in my decades of investment experience is that the habits of successful investing are often contrary to common human behavior. This is why we seek to ignore the crowd and the noise that accompanies them. I have been writing about our extensive exposure to U.S Treasury bonds for some time. Currently, Treasury bonds are one of the most vilified assets around, and yet, from 2008-2015, long-term Zero Coupon U.S. Treasury bonds have returned 107.91%, while the S&P 500 has returned 64.89%. During this entire period of time, the crowd was vilifying Treasury bonds and telling investors to favor equities. In this case, following the crowd would have cost you a 43.02% gain. Conclusion While many investors and savers may be frustrated by the lack of interest they are earning on their cash balances, the buying power of their cash continues to rise as the value of the US dollar increases. In this environment, cash and cash equivalents are king, and as major headwinds from global growth concerns and U.S. dollar strength, among other factors, begin to reduce the earnings power of U.S. companies, the market will correct in tandem. Additionally, we face continued market uncertainty surrounding monetary policy and the possibility of a government shutdown later this year, which could cause additional stress on the market. I continue to feel comfortable with the majority of our assets in cash and long-term Zero Coupon U.S. Treasury securities as well as select short positions, with an underweight in equities, favoring cheaper-priced foreign equities over those of the expensive U.S. market.