March 2022

Written By Jason Slowbe

ONE MORE THING...

  • Krugman on Russia/Ukraine

  • Krugman on inflation

  • There’s an ETF for that

  • Buybacks are back

SPIVA reality check

Twice each year S&P Dow Jones Indices publishes their S&P Indices Versus Active (SPIVA) Report.  And twice each year the data is damning of traditional active managers.  

Of course most active managers want investors to believe they have an edge.  What would evidence of such an edge look like?  Certainly not short term performance - if thousands of managers levered up on short-dated far out-of-the-money call options, a few would “win that lottery” and deliver riches to investors, but surely we would not consider those rare riches to be evidence of persistent managerial skill. In the long run, such a strategy is destined to bleed investors dry.

One of the stunning headlines from the most recent SPIVA Report is that 83% of U.S. Large-Cap funds underperformed the S&P 500 Index in 2021.  The stories write themselves: 

  1. Stock Pickers Are Struggling to Beat the Market (WSJ) “It was supposed to be a stock picker’s market… But as 2021 draws to a close, most professional stock pickers find themselves in familiar territory: trailing the benchmark S&P 500 index.”

  2. Active Managers Fail Again as Stock Rotation Lashes Hedge Funds (Bloomberg) “Stock pickers just blew the stock rotation they’ve spent years longing for.”

  3. New report finds almost 80% of active fund managers are falling behind the major indexes (CNBC) “The latest report marks 12 consecutive years the average actively managed large-cap fund underperformed the S&P 500, noted Todd Rosenbluth, CFRA senior director of ETF and mutual fund research.”

  4. Column: Legendary investment guru Peter Lynch says the move to index funds is a 'mistake.' He's wrong (LA Times) “The record isn't any less dismal over longer periods. More than 67% of actively managed U.S. equity funds underperformed the S&P Composite 1500 index, which comprises 90% of all U.S. publicly traded companies, over three years; 72.8% of funds fell short over five years, 83.2% fell short over 10 years and 86% over 20 years.”

When relative performance is not in your favor, perhaps the oldest trick in the book is to redirect to an eye-popping absolute number.  Top hedge funds earn record $65.4 billion for clients in 2021 - LCH data.  Wow, $65.4 billion!  Just don’t read too far into the article though:

  1. “The top 20, including brand-name investment firms TCI Fund Management and Citadel, returned an average 10.5% and jointly managed nearly one fifth of the industry's $3.6 trillion in assets, the data show. Their returns, however, lagged broader stock market gains.” 

  2. “Even though many firms earned billions, stock oriented hedge funds largely lagged the broader stock market S&P 500 index' 27% gain in 2021.”

Perhaps the second-oldest trick in the book is to wait for a short-term occasion of outperformance then blast that headline:  Hedge funds significantly outperform broad markets through a bad start to 2022:  

 

“For the second consecutive month, hedge funds outperformed the S&P 500 Total Return Index which was down -2.99 per cent in February.”

 

You read that right, 2 months is a notable track record worth promoting.  Not quite the 12 consecutive years (144 months) of actively managed large cap underperformance, but you know, this is the playbook - underperform during more frequent up markets, outperform during less frequent down markets, and sell that outperformance to loss-averse investors.  

To be clear, there are strong and legitimate headwinds facing markets these days, so 2 months of outperformance could very well become 6 months or 12 months or more of active managerial outperformance.  But whatever short-term outperformance stands in stark contrast to SPIVA’s consistent findings dating back to the inaugural report in 2002.  Investors that are swayed by this sales pitch are Likely falling for Sir John Templeton’s four most dangerous words in investing - “this time is different”.  

Well, stock pickers are again making the perennial claim that this year will be different(!)  

1. Here is Nigel Bolton, co-chief investment officer of BlackRock’s Fundamental Equity Group, arguing that stock picking will be a key theme for 2022.  

“there will be ‘winners’ and ‘losers’ within all sectors across the market.

That is why I think the theme for next year is going to be stock picking. It’s going to be a good market, I believe, for individual stock pickers, less so for top down macro theme guys.” 

The fact that every sector will have winners and losers is tautological and unhelpful.  The skill to accurately identify those winners and losers, however, is precisely the purported and elusive skill that SPIVA has thoroughly debunked for 20 years now.  

2. Here is Goldman Sachs - Expect a return to more 'normal' investing where stock picking is rewarded

Isn’t this what they said about the COVID dislocation?  And prior environments? 

3. Here is just last year: Stock Pickers Are Struggling to Beat the Market - WSJ

“We believe that we are entering a new environment where the influence of technology is rapidly broadening to impact virtually every industry,” the strategist said. “Moving forward it will become less easy to differentiate between what is and what is not a technology company, and this should broaden out the opportunities across more sectors.”

4. Here is from the LA Times - Legendary investment guru Peter Lynch says the move to index funds is a 'mistake.' He's wrong 

Peter Lynch, famed investor and long-retired but still stock picking apologist, gave an interview to Bloomberg in December during which he was pressed about active management’s long term industry-wide underperformance relative to passive indexing:

Lynch, 77, told Bloomberg that the wholesale move of investors in recent decades from actively managed mutual funds to passive investing — that is, index funds — is "a mistake."

…

Lynch, of course, was the quintessential active investment manager, renowned for his stock-picking skills. Fidelity Magellan Fund, the mutual fund he ran from 1977 to 1990, was the quintessential actively managed mutual fund.

By giving Magellan investors an annualized return of more than 29% — compared with an annualized gain in the Standard & Poor's 500 index of about 15% during the same period — Lynch grew Magellan's assets under management from $18 million to $14 billion, making it the largest mutual fund in the world.

Magellan lost that crown in 2000 to Vanguard's S&P Index Fund, the quintessential passively managed mutual fund.

…

Pressed to comment further on the record of active vs. passive management, he said, "I don't keep score. I’ve got 10 grandchildren. ... That’s what I keep score on.”

But he also pointed to the performance of three Fidelity fund managers to validate his general claim that active beats passive.

It's true that his three exemplars have done well, but many of Fidelity's actively managed funds have not met their benchmarks. That includes Magellan, on an after-tax basis — an annualized gain of 15.3% over 10 years, after taxes on distributions, versus the S&P 500's average gain of 16.63% per year.


Alright, let’s unpack all this a bit.  

First, credit to Lynch for his significant outperformance of the S&P 500 Index in the 13 year period from 1977 to 1990.  Naturally enough, stock picking outperformance was easier before the internet revolution when information flowed more slowly and large investment firms could capture an informational edge on the less-connected masses.  

Second, Jack Bogle created the first index fund for individual investors in 1976, but it was called “Bogle’s Folly” and roundly dismissed by active mangers for many years, including during Peter Lynch’s time running the Magellan Fund.  It wasn’t until the late 2000s when passive indexing gained widespread traction and gave credible competition to active managers:

 
 

All that to say, an important question is whether Lynch could replicate that outperformance in today’s markets.  We will never know, but I feel confident that Lynch’s hypothetical performance today would more closely match Warren Buffett’s over a similar 15 year span from 2006-2021 than Lynch’s own performance from 1977-1990: 

 
 

Finally, I suspect Lynch knows this Likelyhood himself: 

 

Pressed to comment further on the record of active vs. passive management, he said, "I don't keep score. I’ve got 10 grandchildren. ... That’s what I keep score on.”

 

Stating the obvious here, but If active managers were outperforming passive indexing, you know Lynch would be keeping score. 

Here’s Craig Lazzara at the Indexology® Blog (S&P Dow Jones Indices):

 

Earlier this month, we learned that 70% of the institutional investors questioned in a recent poll thought that “markets will favor active management” in 2022. A number of reasons were cited for this belief, prominent among them the high level of concentration in some equity indices. Interestingly, this forecast of imminent active success is just the latest link in a long chain of similar predictions. For example:

  • We were told that falling correlations would produce a “stock-picker’s market” in 2014.

  • A year later, some active managers asserted that, with the market near then-all-time highs, active managers in 2015 were needed to mitigate portfolio risks.

  • More recently, it was claimed that active managers would outperform passive benchmarks due to the high level of volatility in 2019.

 

I will close with Craig Lazarro again, this time writing at Evidence Investor, who asks will 2022 be a better year for active managers, and answers with the friendship-damaging but revealing questions for those forecasters:

 

What did 2014, 2015, and 2019 have in common? In each of those years, a majority of U.S. large-cap active managers underperformed the S&P 500®. Indeed, of the 20 years for which SPIVA® data exist, a majority of large-cap managers outperformed only three times (most recently in 2009). The records for mid- and small-cap managers, and for active managers outside the U.S., are equally disappointing.

In other words—active managers frequently predict that we are, or soon will be, in a “stock-picker’s market,” but the stock-picker’s market, like the fabled Brigadoon, almost never arrives. Whenever you hear a forecast that this will be the year in which active management is vindicated, here are some questions for the forecaster: If you know that active management will outperform this year, did you know that passive would outperform last year? If you knew, why didn’t you say so then? And if you didn’t know then, why should we believe that you know now?

You may end up with fewer friends, but you’ll have more clarity on an important investment issue.

 

The Ackman pivot

Short selling is a tough way to make a buck, but getting a few short calls right can build a lasting reputation.  George Soros shorting the British pound.  Michael Burry shorted mortgage bonds just before 2008.  Bill Ackman shorted FannieMae and FreddieMac in 2007, then shorted Herbalife in 2012, and is now pulling the plug:  Bill Ackman is done with activist short-selling, will focus on quieter, long-term approach

 Look, credit to Bill Ackman - he found success early, even sustained that success for a while, but then got burned.  Prudent management means following the evidence, admitting when you got it wrong, and continually learning.  

In his annual letter Ackman wrote “The aphorism that you ‘don’t need to make it back the way you lost it’ has always resonated with us.”  This is solid advice for every investor, not just short-sellers.

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.  

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Jason Slowbe
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