Spoiling the Party
Can the rise in popularity of ETF ownership be blamed for the poor relative performance of value investors? The Q4 2015 investment commentary of Horizon Kinetics and Pershing Square both point to the strong flow of funds into ETFs as a key reason for market distortions. Horizon Kinetics has actually been writing about this for quite some time in its commentary, and in detail.
Several accomplished value investors drastically underperformed the S&P 500 Index on a relative basis in 2015. Pershing Square, Gabelli, Fairholme, Greenlight, and Berkshire underperformed the S&P between 11% and 22%. Could this possibly be a coincidence? How could all these venerable investors, all with a strong commitment to finding out of favor stocks and stellar long-term track records, stumble simultaneously?
Circular References
Buying begets more buying with ETFs, and selling begets more selling with actively managed funds – or so the reasoning goes. In effect, the shares of certain companies became momentum stocks as inflows keep pumping into these exchange traded instruments. In 2015, the S&P 500 actually delivered a negative 2.7% return without the top ten performers, versus the headline +1.4% performance.
Inflows into ETFs mean that the constituent stocks receive indiscriminate, automatic buy orders, regardless of valuation. The “forced” buying drives up prices, which means better performance and hence even more inflows. On the flipside, companies that are not part of a major index receive no such inflows. Hedge funds and other active managers commit great effort into finding under-the-radar opportunities (and charge considerably higher fees to do so). However, short term underperformance can become a self-reinforcing pattern. If active funds as a group hold similar stocks and underperform, money will flow out of active mandates and into ETFs. This results in essentially forced selling of off-index names as the funds are withdrawn, thereby pulling down their prices. Conversely, if a portion of these funds have in fact been rerouted to ETFs, the result is indiscriminate, forced buying of liquid stocks that comprise the indexes. The resultant inferior performance of stocks held by active managers further reinforces the virtuous cycle.
Why the ETF Phenomenon Should Self-Correct
“Should” is the operative word here. The flow of funds should reverse course if ETFs underperform active strategies. This reasoning is based on the premise that the majority of ETF ownership is dominated by short term investors who will create the same circular reference on the way down. And if it turns out to be the case that selling is indiscriminate of valuation on the way down, this may create interesting long term opportunities for value investors.
Why I’ll Still Always Be a Proponent of ETFs
Although I have neither personally invested in ETFs nor used them in the Starvine strategy, I have no hesitation in recommending them to the layman who just wants exposure to the general stock market.
The fee structure of some of these ETFs is so low (3 basis points or 0.03% per year in the case of iShares Total Stock Market ETF) that it serves as a permanent head-start at the beginning of each year versus any actively managed product. For this reason alone, active managers as a whole will always struggle to beat index returns.
However, before you get the impression that I’m throwing in the towel, I remain confident of the merits of active management. First of all, in order for investors to achieve a result different from the index, they must be willing to do something different from the index. So long as that “something” requires human judgment, it will involve costs (e.g. in-house research staff, subscriptions, possible travel to visit companies). Secondly, there will always be demand for money to be managed to a certain style or philosophy. For example, some investors may prefer to have their funds allocated to companies that offer a combination of low valuations and high business quality, while others may demand a quantitative approach that involves complex algorithms.
In Closing
The problem with all of this discussion is that it’s difficult to prove anything. Unless a survey is completed to show that sellers of these non-index stocks are in fact reallocating the funds to ETFs, we can only make imputations. We cannot know ahead of time with any degree of certainty that funds will necessarily find their way back into active strategies, should an exodus out of ETF products occur.
Ultimately, anyone who signs up to a long term value strategy is putting their faith in a certain logic: buying companies for significantly less than they are worth should prove to be profitable over the long haul. The chickens should always come home to roost, theoretically. Value investing works in part because not everyone will adopt it. Why? It doesn’t work reliably if you need short term results. In fact, as a style, value goes out of style for years at a time. The year 2015 was generally unfriendly to value investing and tested the patience of many a practitioner who diligently researched out of favor, off-index names.
As for index ETFs, they are here to stay – their incredibly low fees guarantee that. To the extent that they create market dislocations from time to time, I see it as an opportunity despite the near term headache. Remember that the pendulum swings both ways.
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