June 2022

Written By Jason Slowbe

ONE MORE THING...

  • Ummm, no

  • Bad process

  • Was Cathie Wood lucky?  

  • Robo advisors, Human interests  

  • Janet Yellen had a rough day

When doing nothing adds value

The story goes something like this:

  1. The so-called “smart money” buys undervalued shares.  Price goes up.

  2. The so-called “not-as-smart money” sees the next hot stock and does not want to miss out.  They buy at the highs.

  3. The “smart money” sells to the “not-as-smart money” to capture their profits.  They might even short the stock.  Price goes down.

  4. Fearing further losses, the “not-as-smart” money sells at a loss to avoid further losses.  Who is buying from them?  Loop back to #1.

This story is not perfect.  Like, sometimes the “smart money” is not very smart:

  1. Bill Hwang of the now-collapsed Archegos Capital Management used extreme leverage to continually buy a few stocks, used the paper profits to lever up even more, and, well, the obviously predictable happened.  A small pullback triggered margin calls on all that leverage, Hwang could not meet those calls, and Archegos collapsed.  Archegos allegedly had $20 billion in liquid assets!  Hwang was a star protégé of Julian Robertson!  Most people would consider this “smart money”.  I dubbed this infamy “Arche-gone”. 

  2. Gabe Plotkin of the now-shuttered Melvin Capital shorted GameStop in the meme stock mania of early 2021.  Plotkin played the losing game of shorting that eventually caught up to him.  Plotkin would go on to try convincing his investors to give him a clean reset of the high water mark so he could resume charging them fees before regaining their losses, his investors refused, and Plotkin had no choice but to close the fund and cease managing outside money.  Of this tone-deaf plan I asked “Gabe, what the??!!!”.  Melvin Capital had over $12 billion in AUM!  Gabe Plotkin was a Steve Cohen protege!  Previously, Ken Griffin said "I think Gabe Plotkin is one of the finest investors of his generation"!  That’s gotta be considered “smart money”.

Of course Hwang and Plotkin are not necessarily typical or representative of the entire population of “smart money”, and past performance is not necessarily indicative of future results.  But without the benefit of 20/20 hindsight, many investors look at large assets under management (AUM) as a proxy for a quality process, and that’s a very flawed proxy.  

Anyway, one of the core messages of the traditional active management industry is that investors need to pay them, because they are the “smart money” and can make better investment decisions on their behalf.  Active management claims that continual maneuvering in your portfolio is critical to achieving investment success.  The more active you are, the more responsive you can be to ever-changing market dynamics.  And by corollary, the less active you are, the more you will be subject to allegedly preventable losses.  And who wants that?!!  

Except that the performance record of traditional active managers - the “smart money” - is quite bad.  

Here’s from Morningstar’s Active/Passive Barometer, February 2022:

  • “Last year, 45% of the active funds across the 20 Morningstar Categories included in our analysis both survived and outperformed their average passive peer.” (pg 2)

  • “In general, actively managed funds have failed to survive and beat their average passive peer, especially over longer time horizons; only 26% of all active funds topped the average of their passive rivals over the 10-year period ended December 2021.” (pg 2)

  • Active fund performance, defined as surviving and beating their average passive peer, decreases significantly over time, indicating a structural trend that they regress to their underperforming mean from 1, 3, 5, 10, 15, and 20 year durations:

And here’s from the Standard & Poor’s Index Versus Active report (SPIVA) ending December 2021:

 

Source: Standard & Poor’s Index Versus Active report (SPIVA) ending December 2021

 

Slightly different methodologies and metrics, but same story - traditional active management is not performing.  

These studies are net-of-fees, so part of the underperformance can be attributed to the higher commissions and other fees associated with more frequent trading.  However, these studies generally do not account for tax efficiency, and doing so makes the findings even worse.  

Each investor’s tax situation differs of course.  In general though, holding securities one year or less incurs higher short-term capital gains tax rates, but holding securities longer than one year incurs lower long-term capital gains tax rates.  For example, in 2021 a Married filing jointly investor with taxable income of $200,000 would pay a 24% short-term capital gains tax rate but only a 15% long-term capital gains tax rate (Turbotax).  This means active managers have an even more difficult task to beat passive investing that optimizes for long-term capital gains tax rates.

All of which brings us to the headline of when “doing nothing adds value”.  Markets of course have been extremely volatile this year in the face of raging inflation and recession fears.  Investors should remember, however, that past volatility does not determine the risk of investing, not all volatility is created equal, and psychological biases like loss aversion, base rate neglect, and herd mentality can introduce additional risks that lead to systemic underperformance.  

The cyclic story with which I opened this segment involves investors buying near the top, holding on the way down, selling in pain near the bottom, missing the recovery, buying back in near the top, rinse-and-repeat.  Active management leads too many investors into this cycle - sometimes doing nothing is the best thing to do.  Here’s an evergreen post from Institutional Investor, When Doing Nothing Is the Best Thing To Do:

 

"Volatility itself is not risk; it is noise. It is the interim discomfort we as investment professionals must absorb, withstand and manage to achieve the ultimate objective: generating the required rate of return over the investment horizon.

On the other hand, volatility can create a risk: that we reduce our market exposure at the point of maximum psychological pain; in other words, we sell at the bottom. Such behavior is deleterious to long-term investment results. While it certainly feels good to proactively do something and alleviate the mental anguish of a portfolio drawdown, sometimes the best thing we can do is simply nothing. "

 

This idea that managers can add value by tempering investors’ fears and loss aversion is certainly not new.  Effective management enables investors to do nothing precisely when the payoff for doing so is highest, namely when large numbers of market participants tap out and send shares on sale.  These are volatility-induced opportunities for outperforming, available only to those who are prepared to seize that opportunity.

But that’s hard!  And, what are investors paying managers to do if they do, well, nothing?  The answer is this:

Thinking in Likelyhoods: doing nothing is itself an active decision.  

Jesse Felder made this Master the Art of Doing Nothing point this way:

 

Perhaps the most important lesson about investing I've learned is when there is nothing to do, do nothing. The problem is nothing may actually be the hardest thing to do. We all want to feel like we are being proactive and that requires doing something even when there's nothing to be done. So it takes a great deal of discipline to resist the urge to do something and commit to doing nothing. In that way, however, committing to doing nothing is probably the most proactive thing to do.

 




A milestone in the democratization of investing

I write often that traditional active management is not performing.  Well, the first quarter this year brought a HUGE moment in the long, structural trend from active to passive investing: the total amount of passively managed net assets has eclipsed the total amount of actively managed net assets.  Investors are speaking with their dollars, allocating less to active management and more to passive indexing.  

 
 

In this timely piece from Morningstar, Nobody Likes Index Funds, Except Investors, they note that disruptive success attracts criticisms from the disrupted.  And that’s fine for investors.  




The best days will come when you least expect them

I have no idea when the market will bottom.  Nobody does, even those who confidently make such forecasts.  And past performance is not necessarily indicative of future results, so this time could be different, who knows?  


But there is history worth considering.


Here’s my April Public Service Announcement, via the American Association of Individual Investors:

 

As inflation is taking its grip and investors are bracing for the unknown effects of central banks tightening monetary conditions, this is a reminder from the American Association of Individual Investors: Don't Let Fear Cause You to Miss the Best Days in the Stock Market.  

History has shown the best days to be in the market tend to occur very close to the worst days. More importantly, if you miss those best days because you were out of the market on concern about what might happen, you will forfeit a large amount of wealth.

…

“If you stayed invested in the S&P 500 from the start of 1928 through March 9, 2022, you would have earned 23,987.2%. If you were out of the market for the 10 worst days over that period, you would have seen your return increase to 26,525.8%. Perhaps most surprising, though, was the impact of missing out on the 10 best days. Sitting on the sidelines for 0.04% of the days over this period would have dropped your return to 7,864.5%.”

 


In a related statistic from March 2021, Bank of America found that since 1930 if an investor missed the 10 best days of S&P 500 returns each decade, the total return would be 28%, but holding steady through this time their return would have been 17,715%.  You do not want to miss those 10 best days.  


But who knows when those 10 best days will come!  The history shows that the 10 best days in each decade tend to be clustered together, and additionally tend to occur shortly after the worst days when investor sentiment is strongly tilted toward selling.  


Here are those 10 best and worst days by Change (%) from 2011 through 2020:

 

Source: Interactive Brokers, Likely Capital Management

Past performance is not necessarily indicative of future results.

 

That’s why fear & greed metrics, investor sentiment, and extreme selling are often considered contrarian indicators.  Like this piece from Bloomberg: Hedge Fund Selling Was Never More Furious Than in Last Two Days .  And this stat from Mark Hulbert via Marketwatch: Those who buy stocks the day the S&P 500 enters a bear market have made an average of 22.7% in 12 months.  

The inevitable recovery will happen once net selling is exhausted.  And when this happens, we don’t want to miss the 10 best days.


ONE MORE THING…

The information and opinions contained in this newsletter are for background and informational/educational purposes only.  The information herein is not personalized investment advice nor an investment recommendation on the part of Likely Capital Management, LLC (“Likely Capital”).  No portion of the commentary included herein is to be construed as an offer or a solicitation to effect any transaction in securities.  No representation, warranty, or undertaking, express or implied, is given as to the accuracy or completeness of the information or opinions contained herein, and no liability is accepted as to the accuracy or completeness of any such information or opinions.  

Past performance is not indicative of future performance.  There can be no assurance that any investment described herein will replicate its past performance or achieve its current objectives.

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Jason Slowbe
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