May 2024
IN THIS ISSUE
Lucky vs. Repeatable
Ted Seides wishes he met Dave Ramsey
Dead as a hedge fund
If you are new to Likelyhoods, or to indexing, or to “experts” whose expertise is not very expert, you may be surprised that For 14th year in a row, the S&P 500 beat the majority of actively managed funds (MarketWatch):
Sixty percent of all active large-cap U.S. equity funds lagged the S&P 500 in 2023, a scorecard report from S&P Dow Jones Indices shows. The price of the S&P 500 climbed 24.2% last year for a total return of 26.3%, according to FactSet data.
The cost of investing in active funds is typically higher than in passive ones that simply track a widely-followed U.S. equities index such as the S&P 500. Investors may be willing to pay up for active funds in the hope that the managers who run them will deliver market-beating returns.
Yet a majority of large-cap U.S. equities funds have underperformed the S&P 500 SPX in each of the past 14 years, according to the report from S&P Dow Jones Indices.
The data come from the SPIVA (S&P Indices Versus Active) Report by S&P Dow Jones Indices - and the long term trend in the data are even more damning than this article reveals:
After 15 years, a whopping 87.98% of All Large-Cap funds underperformed the S&P 500 Index. The trend over the long term is clear - the more time passes, the more active funds underperform the Index. The arguments supporting active manager expertise weakens with every passing year.
The performance gap is exactly why the Chairman of the ultra-rich investors’ club Tiger 21 is saying Hedge funds are ‘dead as a doornail’:
“Our members realized they could do better on average with more exposure to index funds like the QQQ and SPYs with more liquidity and less fees, and likely higher returns over the last decade,” Sonnenfeldt said.
The Invesco QQQ ETF, an exchange-traded fund that tracks the performance of the Nasdaq-100, rose 55% in 2023. SPY, which stands for the SPDR S&P 500 ETF, gained almost 25% last year.
Global hedge funds returned 13.3% last year, rebounding from -6.8% in 2022, according to data from investment company Preqin.
Between the last quarter of 2014 and the end of 2023, the industry has seen net outflows of more than $217.3 billion, said Charles McGrath, assistant vice president at Preqin’s Research Insights.
Why pay for active underperformance when investors can simply buy a low cost S&P 500 Index ETF and capture better net-of-fees returns?
Well, that’s exactly what investors have been doing. Here’s a 30 year chart of fund assets invested in Active versus Passive funds. For the first time in history, as of December 31, 2023, total Passive fund assets surpassed Active fund assets: It’s Official: Passive Funds Overtake Active Funds (Morningstar)
Some active investors - particularly those whose very expertise is challenged - push back on this trend. Like David Einhorn of Greenlight Capital who argues that Markets are ‘fundamentally broken’ due to passive investing:
‘I view the markets as fundamentally broken…Passive investors have no opinion about value. They’re going to assume everybody else has done the work.’
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“Value is just not a consideration for most investment money that’s out there. There’s all the machine money and algorithmic money which doesn’t have an opinion about value it has an opinion about price: ‘What is the price going to be in 15 minutes and I want to be ahead of that,'” he explained.
Amid what’s left of active management, “the value industry has gotten completely annihilated,” he said.
That can make for a vicious circle. As money moves from active management to passive, value managers are forced to deal with redemptions. They then sell their holdings, which causes value stocks to fall further, triggering more redemptions, Einhorn explained.
“All of a sudden the people who are performing are the people who own the overvalued things that are getting the flows from the indexes. You take the money out of value and put it in the index, they’re selling cheap stuff and they’re buying whatever the highest multiple, most overvalued things are in disproportionate weight,” he said.
Then the active managers participating in that part of the market get flows and they buy even more of the overvalued assets.
As a result, stocks, rather than “reverting toward value” instead “diverge from value,” Einhorn said. “That’s a change in the market and its a structure that means almost the best way to get your stock to go up is to start by being overvalued.”
Interesting argument - but one that largely deconstructs itself. If passive indexing is creating inefficiency in market pricing, does this not create ripe opportunities for active managers to profit from those mispricings? Here’s Morningstar with Index Funds Have Officially Won:
If indexing has made the stock market less rational, that change should represent an opportunity for active fund managers, rather than an obstacle. After all, they have no role to play if equity valuations are fully rational. They are only useful if stocks are somehow mispriced. By this claim, then, indexing has improved active managers’ situations.
Regrettably, it has not. Although indexing has become far more popular than in the past, tens of trillions of dollars remain in the hands of active investors, including a record number of Chartered Financial Analysts. Also, technology has enabled a higher level of investment research, by more parties, than ever before. To be sure, indexing at some point could become so prevalent as to disrupt stock prices. Not yet, though.
And here’s Ben Felix in The Index Fund Bubble:
To understand how index funds might affect stock prices, we need to understand how prices are set. Prices are set by trading. Each trade is a vote for the price going up or down. The aggregation of all of these votes is the current price, which is the market’s best guess at the actual value of a company. If index funds are the only entities placing trades, buying up more of the biggest stocks to match the market cap weighted indexes that they are tracking, then there could be some serious issues. Index funds have grown dramatically in terms of assets under management. This is what is causing alarm bells to go off.
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Assets under management do not set prices. Trading sets prices. The relevant question is not how much of the market is indexed, but how much of the trading index funds are doing. If index funds are not doing the majority of trading, then it is still the active managers dominating price discovery. The majority of ETF trading is happening on the secondary market. That is ETF unit holders trading with each other. It is only when there are deviations between the price of the ETF and the value of the underlying securities which you can think about as excess supply or demand for the ETF units, that the authorized participant will create or redeem ETF units.
Unlike secondary market transactions, the process of creating and redeeming ETF units requires trading in the underlying stocks. In a 2018 paper titled Setting the Record Straight: Truths about Indexing, Vanguard demonstrated that the vast majority of equity ETF trading, 94% on average, is done on the secondary market. Meaning that ETF unit holders are buying and selling from each other without touching the underlying securities. In their 2017 paper, Index Investing Supports Vibrant Capital Markets, Blackrock presented a similar figure showing that ETF creation makes up a tiny fraction of U.S. equity dollar trading volume.
This point is important in understanding why index funds make up such a small portion of overall trading. But it is also important in understanding why concerns about the liquidity of the underlying holdings are overblown. Most of the trading does not touch the underlying securities at all. The Vanguard paper that I mentioned reports that of all trading activity in the stock market, index strategies are only responsible for about 5% of it. Think about that. Only 5% of total trading is executed by index funds, while active mandates are executing the rest. Blackrock similarly estimates that for every one dollar of stock trades placed by index funds, there are twenty-two dollars of trades placed by active managers. This destroys the price discovery argument. Price discovery, which is driven by trading, is still dominated by active managers.
Thinking in Likelyhoods, I’m not convinced by Einhorn’s reasoning - seems Likely that plenty of active managers remain in the market to perform price discovery, and plenty of underperforming active managers remain to be squeezed out of business for being unable to profit from market mispricings.
Maybe “dead as a hedge fund” will catch on.
ONE MORE THING…
Lucky vs. Repeatable. Nice piece from Housel on distinguishing Luck - what is not repeatable - from Skill. See also Michael Mauboussin’s take on Luck vs. Skill in his book Success Equation: Untangling Skill and Luck in Business, Sports, and Investing.
Ted Seides wishes he met Dave Ramsey. Dave Ramsey says it’s easy to pick actively managed funds that will beat the S&P 500 Index. But why didn’t Ramsey take Warren Buffet’s index fund bet that only one manager (Seides) was willing to accept… and who lost disastrously? ‘Are you smarter than Warren Buffett?’: LA man attacks David Ramsey for recommending actively managed funds
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