Days of Being Passive-Aggressive

Originally published on 7 August 2017

“Nothing to Do with Value”

The May 5, 2017 edition of Grant’s Interest Observer featured an interview with Mr. Frank Brosens, co-founder of Taconic Capital. Brosens, who succeeded Goldman Sachs’ risk arbitrage department after Bob Rubin became U.S. Treasury Secretary for President Clinton, and a master of risk, all sorts of risks. He expresses his concerns over the investors’ behavior who ignore value.

“Nothing to do with value”? The phrase rings a bell. Only begin to consider the $21 trillion or so of today’s invested capital that belongs to value-indifferent stewards. The central bankers couldn’t care less about price or value; they buy bonds (the Swiss and the Japanese also buy stocks or ETFs) to promote growth or inflation or some other macroeconomic variable, not to make money, though — to be sure — they do “make money.” They print it.

Public investors in index funds are no more attuned to value than the central bankers are. As indexed investors, in fact, they must be value-avoidant, or at least, value-agnostic, as index funds mechanically buy stocks according to the size of their market capitalization. Size trumps value.

And what do the buyers of exchange traded funds care about ratios of price to earnings or operating income to fixed charges? Most buy ETFs to “gain exposure” to a certain asset class, industry or investment concept. You can’t pretend to pick stocks or bonds when the ETF you buy owns dozens of them.

Value-agnostic is probably a new buzzword to be successful in today’s investment world. This investor “preference” clearly pushed the valuation to the level we have seen twice in the last 130 years… the Black Tuesday in 1929 and the first Internet Bubble in 2000, measured by Case Shiller P/E Ratio. (Exhibit 1)

So, what really is the passive investing? Howard Marks’ recent letter, There They Go Again… Again, describes a brief history (50 years) of passive investments in an excellent way.

Fifty years ago, shortly after arriving at the University of Chicago for graduate school, I was taught that thanks to market efficiency, (a) assets are priced to provide fair risk-adjusted returns and (b) no one can consistently find the exceptions. In other words, “you can’t beat the market.” Our professors even advanced the idea of buying a little bit of each stock as a can’t-fail, low-cost way to outperform the stock pickers.

John Boggle put that suggestion into practice. Having founded Vanguard a year earlier, he launched the First Index Investment Trust in 1975, the first index fund to reach commercial scale. As a vehicle designed to emulate the S&P 500, it was later renamed the Vanguard 500 Index Fund.

The concept of indexation, or passive investing, grew gradually over the next four decades, until it accounted for 20% of equity mutual fund assets in 2014. Given the generally lagging performance of active managers over the last dozen or so years, as well as the creation of ETFs, or exchange-traded funds, which make transacting simpler, the shift from active to passive investing has accelerated. Today it’s powerful movement that has expanded to over 37% of equity fund assets. In the last ten years, $1.4 trillion has flowed into index mutual funds and ETFs (and $1.2 trillion out of actively managed mutual funds).

J.P. Morgan publishes annual Global ETF Handbook, which estimates total ETF assets under management reached $4.0 tn globally (Exhibit 3) and the number of listed ETFs globally has grown to more than 7,000. In the United States alone, there are more than 2,000 ETFs. J.P. Morgan also estimates the number of listed companies in the United States is roughly 4,000, down 46% from its peak of 8,025 in 1996.

The size of the US ETF market stands at $1.7 tn in domestic equity funds (equivalent to 6.4% of the total US equity market cap of $26.7 tn). J.P. Morgan says “as ETFs became an increasingly important part of US markets, investors started using ETFs as a hedging and positioning tool. In recent years ETF trading volume represented ~25–30% of the total average US equity trading volume (Exhibit 4), meaning investors trade ETFs 6x more frequently than individual stocks. During the 2008–2009 financial crisis, ETF represented almost 50% of the total average US equity trading volume and, not surprisingly, the ratio of ETF to total trading volume has a significantly high correlation to VIX, which measures expected volatility of the stock markets.

So, why is Brosens, the master of all sorts of risks, worried so much about passive investments, which believed to reduce, not increase, costs of your portfolio? The reason — we became too passive, or passive-aggressive.

Like Brosens, Marks also expresses his concerns and negative impacts of the excessive popularity of the passive investing:

Remember, the wisdom of passive investing stems from the belief that the efforts of active investors cause assets to be fairly priced — that’s why there are no bargains to find. But what happens when the majority of equity investment comes to be managed passively? Then prices will be freer to diverge from “fair,” and bargains (and over-pricings) should become more commonplace.

Even Bogle, the father of passive investing, recognizes the problem. At this year’s annual shareholders meeting of Berkshire Hathaway in Omaha, he said:

“If everybody index, the only word you could use is chaos, catastrophe.”

“There would be no trading, there would be no way to convert a stream of income into a pile of capital or a pile of capital into a stream of income. The markets would fail.”

And, if investors become excessively passive, or passive-aggressive, the valuation of the equity markets will be distorted or skewed. To explain this, Marks quotes a brilliant comment from Barron’s:

With cap-weighted indexes, index buyers have no discretion but to load up on stocks that are already overweight (and often pricey) and neglect those already underweight. That’s the opposite of buy low, sell high.

Marc Faber, our favorite macroeconomics commentator, gives a similar observation in his May 2017 edition of The Gloom, Boom & Doom Report, A More Promising Future for Active Managers. (we highly recommend everybody subscribe Faber’s newsletter. For $800, you will receive 12 newsletters full of deep insights and investment ideas!)

By definition, an index fund will always have its largest exposure to the highest market capitalization stocks, which are in most cases the most expensive ones as well. Think of Japan in 1989 when its stock market capitalization made up 50% of global stock market cap. A global equity index fund would have had 50% of its holdings in ludicrously overpriced Japanese equities, whereas any responsible active manager (a money manager who remembers that fund management entails a fiduciary duty) would by 1989 have been significantly underweighted Japanese equities.

When you look at the stock performance difference between The Big 5 (Apple, Microsoft, Amazon, Google and Facebook) vs. S&P 495 (S&P 495 is an index of 495 or so companies included in S&P 500 except for the Big 5) as well as the concentration of NASDAQ 100 in the largest five stocks.

Some of you might remember our article titled Thoughts on Catastrophic Losses and Hidden Risk of Diversification. We discussed that J.P. Morgan Asset Management found that, from 1980 to 2014, 40% of all stocks in the United States experienced “Catastrophic Loss”, which is defined as a stock that experienced a 70% of more decline from its peak and never recovered back to the 60% level from its peak. And, importantly, for Information Technology companies, almost 2/3 of companies experienced the Catastrophic Loss.

Days of Being Passive-Aggressive

“It is passive-aggressive behavior, the donning of a mask of amiability that conceals raw antagonism toward one’s competitors, even one’s friends.”

— Hilary De Vries, New York Times

Yuddy: I’ve heard that there’s a kind of bird without legs that can only fly and fly, and sleep in the wind when it is tired. The bird only lands once in its life… that’s when it dies.

Yuddy: Hey, have you heard of a kind of bird…

Tide: [interrupting] The kind without legs, right? This kind of nonsense can only fool the girls!

— From Days of Being Wild

Passive investing is like Yuddy’s bird story (in this case, he is referring to himself). Its gloomy fate attract sympathy from equally gloomy girls like a quiet lass named Su Li-zhen, who works at a sports arena, and glitzy showgirl named Mimi. Perhaps due to his unresolved Oedipal issues, he passively lets the two compete for him, unable or unwilling to make a choice. Eventually, Yoddy lost both girls.

We are not a Yuddy’s bird. We have legs and know when to fly, how to land. We know when to buy, how to sell. However, for active investment managers who believe in fundamental-driven, long-term and concentrated investment approach, making life during the Days of Being Passive-Aggressive hasn’t been easy.

In the same May 2017 letter, Faber also shares his experiences with Overlook Partners Fund in Hong Kong, which was founded by Richard Lawrence in 1992 (note: we have no investment in Overlook). Outlook has one of the best long-term performance records in Asia (and potentially in the world) by delivering 13.9% of returns over the last 25 years, which includes the Asian Currency Crisis in 1997–1998, the first Internet Bubble in 2000 and the Financial Crisis of 2008. Overlook’s business is based upon the following principles:

  • One fund and one co-investment fund
  • One asset class
  • One investment philosophy
  • Focused portfolio with 20–22 holdings
  • A small team incentivized by long-term compensation

As the world is dominated by the passive and valuation-agnostic investors, in the long-run, there will be more and more opportunities for the long-term value-focus investors like Overlook. The long-term focus means we do not, and are not supposed to, make money all the time. When the equity markets will eventually collapse, there will be many big babies thrown out with bathwater. We just don’t know if it is happening tomorrow or three years from now.

Days of Being Wild is a 1990 Hong Kong drama film directed by Wong Kar-wai. The movie is set in Hong Kong and the Philippines in 1960–61. Yuddy, or “York” in English (Leslie Cheung), is a playboy in Hong Kong and is well known for stealing girls’ hearts and breaking them. Yuddy learns from the drunken ex-prostitute who raised him that she is not his real mother. Hoping to hold onto him, she refuses to divulge the name of his real birth mother. The revelation shakes Yuddy to his very core, unleashing a cascade of conflicting emotions. His first lover in the film is Li-zhen (Maggie Cheung), who suffers emotional and mental depression as a result of Yuddy’s wayward attitude. Li-zhen eventually seeks much-needed solace from a sympathetic policeman named Tide (Andy Lau). Yuddy’s next romance is with a vicious cabaret dancer whose stage name is Mimi (Carina Lau). Unsurprisingly, Yuddy dumps her too and she begins a period of self-destruction. Yuddy initiates romantic relationships but refuses to commit to the relationship and is unwilling to make compromises.



Shinya Deguchi @ Star Magnolia Capital

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