Roger Montgomery- cuffelinks.com.au
11 May 2017
Two years ago in Cuffelinks, I wrote an article entitled Index funds invest in the bad and the good, and said; “The blind buying of mountains of stocks simply because they are in an index will drive mispricing that active managers can rely on to outperform the same index. As more investors flock to the index, the argument trotted out that most active fund managers fail to beat the index will become less true, if not false. The hitherto reason for investing in the index will break down, just as active managers reward their investors with greater outperformance over the long run.”
I also added, “Index investing, in particular when it is directed to cap-weighted equity indices, is dumb investing. When Warren Buffett recommended index investing to the masses, he made the point that it suits the ‘know-nothing investor’. That is, the investor who has no interest in understanding a business or valuing it.”
Low interest rates have driven high prices
Since then, some infinitely smarter and more influential researchers have warned investors against index investing. In late 2016, Steven Bregman of Horizon Kinetics presented at the Grant’s Interest Rate Observer Conference a paper entitled, Indexation: Delivery Agent of The Great Bubble. He warned investors that their switching of trillions of dollars in the US from actively managed funds into index ETFs was driving them back towards the same idiosyncratic risk they were seeking to avoid by selecting passively managed index funds.
[A 40 minute video of Bregman’s presentation is linked here].
Bregman noted, as I have here and here at Cuffelinks, that the reluctance to hold cash has “very likely created balance sheet bubbles.” There is no doubt in my mind that the lowest interest rates since Captain Cook first crossed the Antarctic Circle have driven the record prices in everything from collectible cars and low digit number plates to wine, art and Brisbane apartments.
But in addition, many investors have simply given up on direct equities and even actively managed funds and opted instead for cheaper alternatives such as index ETFs. These index funds ignore the long-term drivers of returns, such as ‘value’ and ‘quality’ and buy all the stocks that make up the index the fund seeks to track.
Coincidently, the low interest rates and flat yield curves that have driven investors out of cash and up the risk curve have also reduced incentives for companies to invest for growth and incentivised the payment of dividends. Of course, high-dividend payout ratios mean low rates of reinvested profits, which translates to record high PE ratios coinciding with low growth.
Little or no earnings growth in largest companies
If Australia’s largest companies are paying the bulk of their earnings out as a dividend, the corollary is they expect little or no growth in earnings. Telstra’s earnings per share are little better now than in 2005 and the S&P/ASX200 is no higher today than it was on 16 February 2007 — 10 years ago.
The economics of Australia’s biggest listed companies will not turn significantly more positive in the next 10 years so why should the indices they contribute to produce returns any better? The S&P/ASX200 cap-weighted index fund is not constructed with long-term returns in mind. It merely reflects the trading activity in Australia’s largest 200 companies.
But what if inflows into index ETFs stop flowing in and start flowing out? This is the question Bregman asked in October last year.
The business of ETFs looks good when funds are flowing in. Bregman noted there were 204 ETFs in the US in 2005 but by 2015 there were 1,594. In Australia, there are 179 ETFs. Low fees are one of the carrots used to attract investors to index investing. The other one is selective time frame comparisons of returns. It is true that many actively-managed funds underperformed the index in 2016, but over five years and since inception, many active managers in Australia beat the S&P/ASX200.
Focus on big stocks
The large ETFs tend to concentrate their activity among the big stocks. In the US, this has produced some curiosities. For example, Bregman notes ExxonMobil is “25% of the iShares US Energy ETF, 22% of the Vanguard Energy ETF, and so forth, [but] ExxonMobil is simultaneously a dividend-growth stock and a deep-value stock. It is in the US quality-factor ETF and in the weak-dollar US equity ETF. Get this: It’s both a momentum-tilt stock and a low-volatility stock. It sounds like a vaudeville act.”
This might not seem significant to an Australian investor, but in the past three years, the oil price is down 50%, ExxonMobil’s revenue is down 46%, its earnings per share is down 74%, the dividend-payout ratio is almost 3x earnings and total debt up 129%. Yet the stock was up 4% from the second quarter of 2013 to the second quarter of 2016. Bregman called it “an exercise in levitation” thanks to the distortion of prices by index investing buying.
In Australia, despite, or perhaps because of, our relatively smaller size, the iShares Edge MSCI Australia Minimum Volatility ETF, the Russell Investors Australian Responsible Investing ETF, the Russell Investors High Dividend Australian Shares ETF, the Russell Investors Australian Value ETF and the UBS IQ MSCI Australia Ethical ETF all have Telstra and the big four banks in their top 10 or 15 holdings. Indeed, all the above ETFs held CBA and WBC as their top two holdings and the big four banks as their top four holdings.
The scaling requirement has produced other curiosities in Australia. Funds that label themselves ethical or responsible hold Rio, BHP, Woolworths, and Woodside.
Bregman notes that in the US, the annual share turnover of ExxonMobil is 90% and IBM Corp 128% but the turnover of the SPDR S&P500 ETF was 3,507% or 100% per day! In other words, the average holding period is just one week. What do you think might happen to share prices if ETF inflows turn into outflows given turnover of an ETF is dozens of times higher than that of the underlying securities? On 24 August 2015, Bregman observed a dress rehearsal of what might transpire. On that day, the price of the iShares Select Dividend ETF fell 35% while the NAV dropped just 2.5%.
Could it be that the idiosyncratic risk investors sought to diversify away from by investing in index funds is the same risk they are unwittingly heading headlong into, while the indexes are fully invested and shares are at record price to earnings multiples?
Author of 1955 bestseller The Great Crash, John Kenneth Galbraith, explained the cyclical instability inherent in modern capitalism as stemming from the accumulation of excessive wealth and the fragile nature of the financial system. Galbraith noted, all stockmarket bubbles exhibit “seemingly imaginative, currently lucrative, and eventually disastrous innovation in financial structures”. Bregman suggests the current fascination with index ETFs in the US will not end well.
Roger Montgomery is Chairman and Chief Investment Officer at Montgomery Investment Management. This article is for general information only and does not consider the circumstances of any individual.