Too Active, Too Passive: Too Little Understanding

Dear Fellow Investors:

The wealth management and institutional consulting communities have allowed indexing to be called “passive” investing and stock-picking disciplines to be called “active” management. This implies a mindless approach to indexing and a great deal of busyness to stock picking. A number of recent articles and commentaries have been written which question the viability of stock-picking disciplines in an era of numerous indexing choices and ETF vehicles. We at Smead Capital Management believe these labels are at the heart of a great deal of confusion about what works and what doesn’t work in both equity mutual funds and separately managed accounts.

The latest article we’ve read came on January 22nd, 2013 from George Sisti, a guest writer on retirement planning, argued adamantly against “active” management in a piece called “Forget hot funds and market-beating managers”. His thesis: since nobody can predict the future or where the market is going each year, nobody can beat the stock market over long stretches of time.

Why not? Something called an efficient market — think of it as money manager gravity — which keeps even the smartest managers from outperforming the market over the long haul. In an efficient market, the current price of a stock is the consensus opinion of all those smarty types’ collective judgment. If their consensus opinion is that XYZ stock is undervalued, they will rush to buy it and its price will rise. Conversely, if they believe that XYZ is overvalued, they will sell it and its price will decline.

We believe it is correct to be skeptical of a majority of equity mutual funds, but believe thinkers are wrong about long-duration outperformance. We believe there are actually a number of very meritorious stock-picking disciplines which do add value for investors and there are a number of factors which argue in favor of effective “active” management.

FACTOR ONE—Valuation Matters Dearly
Eugene Fama and the others who came up with the efficient market theory have written extensively about mechanical valuation-oriented stock-picking disciplines. For example, Fama and French concluded that the lowest price-to-book ratio (P/B) companies outperform the market and the other categories. Even efficient market theorists have identified ways to beat the stock indexes. Here at Smead Capital, we found that Fama-French like academic studies by Bauman-Conover-Miller, David Dreman and Francis Nicholson all came to the same conclusion—VALUATION MATTERS DEARLY! Take any valuation metric like price-to-earnings, price-to–dividend, price-to-book, or price-to-sales and the lowest 20-25% of the companies outperform the index over both one and multiple-year holding periods. Additionally, it works with annual rebalancing and in Nicholson’s study as a static portfolio. In fact, the benefit of buying cheaply and holding statically grows more and more each year in his study.

FACTOR TWO—Index Strengths and Weaknesses
Most discussions don’t delve into what indexes do. What the “passive” indexes do well or what they do poorly in comparison to actively-managed equity funds is never dissected. In a piece we wrote in March of 2010 called “Long Duration Common Stock Investing”, we explained what we believe the indexes do well and what they do poorly. Index expenses are low, turnover is low, trading costs are minimal, winners are held indefinitely, and market-cap weighting causes winning stocks to be magnified.

In our opinion, there are a few things the indexes do poorly. First, an index has no way to get away from poor-performing companies like General Motors in 2008 or Kodak during the last decade; they are usually forced to ride them to zero. Additionally, the index suffers from massive capital misallocations like the tech bubble in the late 1990’s and energy stocks in 1980. There is no way for the index to get away from a concentration in immensely popular industries and sectors and no way to over-allocate to undervalued industries and sectors.

FACTOR THREE—Rearview Mirror Attitude Adjustment
A majority of commentators fail to consider the market’s range-bound nature since the start of 2000 and how that has colored advisor attitudes. Why is indexing even called “passive” and why are stock-picking organizations called “active” managers? Indexing is considered “passive” because of the attitude needed by the owner not the overseer. In the period from 1992 to 2009, the S&P 500 index had 4.63% turnover. Companies were bought out and left the index or performed so poorly that they were removed from the index. Standard and Poor’s then chooses a replacement from among companies which have a certain market capitalization. In our words, the index is not passive, it is automated and mechanical.

The mechanical nature of “passive” funds flourished since 2000 for two reasons: first, the index rides it winners to a fault and is capitalization weighted. Big multiple-year and multiple-decade winners are allowed to run uninterrupted; second, index funds spend almost nothing on trading costs or bid and ask spreads. The Boston College Center for Retirement Research concluded that large-cap US equity funds in 401(k) plans spent 1.31% annually in trading costs on average. Compare that to .05% or less annually for S&P 500 Index funds. It’s a 100-meter dash annually for the index, while the funds are running about 102.75 meters in the US large-cap space each year to keep up.

FACTOR FOUR—Passive Index Popularity Changes Future Performance
The fact that the popularity of indexing has already become a huge part of long-only US large-cap equity investing hasn’t been factored into future result expectations. Therefore, it is our opinion that significant implications exist today for finding long-term alpha when there is less money being fed to “active” management and fewer long-duration stock-picking disciplines being practiced in the long-only space.

The extra distance in the dash is why they are called “active” funds. Annual portfolio turnover in equity mutual funds has approached 100% in recent years. We believe investors in these funds are losing out two ways. They are throwing away returns directly through trading costs and indirectly by cutting off their best performing individual stocks due to the impatience of the manager. A few years ago, the manager of the T. Rowe Price “New Horizons” fund, Jack LaPorte, retired. When asked why his fund had done so well over 15 years he said, “My average hold was four years, while the average portfolio manager [held for] about 10 months. I don’t know how others can make that a successful way to manage money.”

To understand how important costs are to the index advantage you only need to compare what percentage of US large-cap blend equity funds outperformed the market over the last five and ten-year periods as compared to a Russell universe for US large-cap equity separately managed accounts run by many of the same managers. In Morningstar’s database, 35% of large-blend US equity funds beat the S&P 500 index over five years and 40% beat over ten years. In Russell’s universe of US large cap equity portfolios, 60% beat the S&P over five years and 82% over ten years. The difference in Russell’s universe is it is gross of management fees. The management fee for SMAs compares to the expenses associated with running the funds (annual net expense ratio), which includes both management fee and operating expenses born by shareholders. If the Russell universe managers charged an average of .65%, this would mean that .65% less trading cost or operating expense in a fund theoretically doubles the number of index-beating funds over ten years.

The most germane quote on the attraction to indexing comes from William Sharpe, who helped create the Capital Asset Pricing Model (CAPM) and the Sharpe ratio:

Should everyone index everything? The answer is resoundingly no. In fact, if everyone indexed, capital markets would cease to provide the relatively efficient security prices that make indexing an attractive strategy for some investors. All the research undertaken by active managers keeps prices closer to values, enabling indexed investors to catch a free ride without paying the costs. Thus there is a fragile equilibrium in which some investors choose to index some or all of their money, while the rest continue to search for mispriced securities. Should you index at least some of your portfolio? This is up to you. I only suggest that you consider the option. In the long run this boring approach can give you more time for more interesting activities such as music, art, literature, sports, and so on.

We emphatically believe that what Sharpe said in 2002 does not apply today for two reasons. The range-bound market of 2000-2011 rearranged the behavior of most stock pickers, in particular the thinking of equity managers and people who research managers. The difficult markets damaged the general belief in the merit of “buy and hold” common stock investing.

In the opinion of SCM, “Active” managers—or what we like to call “way too active” managers—seem to have massively migrated away from stock selection that is based on long-term or long-duration time periods. As we see it, the proliferation of hedge funds and an urge to satisfy financial advisors and managers has increased their activity levels, driving them to move in and out of markets too quickly. Thus, we maintain, that the historically-high average turnover among equity funds, scarcity of effective long-duration analysis, and newly normal expense levels/trading costs doom the “active” management community!

Ironically, the other thing that Sharpe couldn’t have known in 2002 was the move into ETFs and their open-armed adoption in the large-cap space of “passive” index investing. Remember, Sharpe’s attitude was based on the efficiency of all those professionals doing effective and usually long-term research. In the process, they were squeezing the under and over-valuation out of the market. A nearly four-year bull market in stocks is being met by massive and continuous liquidation of funds run by stock-picking organizations. A part of this money is moving to ETFs dominated by indexes causing the efficiency of the market to disappear fairly fast. You could see this in the incredibly high correlations among stocks in the S&P 500 index in the last three years. If the markets are efficient, how could all stocks move simultaneously do to the “risk-on risk-off” trade?

The ultimate irony in all this is the abdication of effective long-duration research and “buy and hold” investing. Huge amounts of capital have fled to indexes which do exactly the thing that “active” managers refuse to do. In this odd way, we believe these circumstances have created a wonderful opportunity to do what the index does well and improve on what the index does poorly. Let me summarize the behaviors that are needed to outperform the market over long time periods.

1. Reasonable management fees or fund operating expenses
2. Low turnover/hold winners to a fault
3. A commitment to valuation
4. Poor performing stocks regularly culled for possible sale
5. Avoidance of overly popular companies, industries and sectors

Here is what we wrote in early 2010:

Ben Inker, research director at Grantham, Mayo and Van Otterloo (GMO), exposed what is wrong with the high level of activity and portfolio turnover at the average actively managed fund. His work shows that 75 per cent of the current intrinsic value of a stock comes from cash flows earned more than 11 years from now. Why are short term business prospects receiving most of the professional investor attention when company durational success should be their focus?

To tie this together we will refer you to a 1984 piece Warren Buffett wrote for the Columbia Business School magazine called “The Superinvestors of Graham and Doddsville”. Buffett argued then that the efficient market theorists were wrong because everyone that he had known over the prior three decades, who practiced the disciplines we described, had soundly beaten the S&P 500 index.

In conclusion, we believe that there are very few stock-picking organizations which are practicing these disciplines today. To paraphrase Buffett, hardly anyone does the discipline, but everyone we know who does it succeeds over long-duration periods. In our opinion, the scarcity of dedicated participants raises the alpha available to the ones who are practicing the discipline. The popularity of indexing and the defensive busyness of “active” managers have created a significant reduction of competition in stock picking. This raises profit margins (alpha) in stock picking, as a reduction in competition does in any other industry. Therefore, we believe that those who advise and manage wealth should make the effort to understand this discipline and benefit from this market dislocation. We believe stock-picking organizations, financial advisors, and institutional investors need to recognize these possibilities.

Best Wishes,

William Smead

The information contained in this missive represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. It should not be assumed that investing in any securities mentioned above will or will not be profitable. A list of all recommendations made by Smead Capital Management within the past twelve month period is available upon request.

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