There’s a growing chorus of commentators who are claiming we are witnessing the structural demise of active stock-picking strategies.
Apparently we are all going to be replaced by artificial intelligence and passive index strategies.
Like all debates, the truth most likely lies somewhere in between.
The fact of the matter is that the majority of active fund managers have failed to beat the returns of their given benchmark. Their inability to beat the benchmark has played directly into the “narrative” of the passive managers who continue to accumulate assets at an unprecedented rate.
If you are going to charge active fees, which are higher than passive fees, then my view is your after fee returns have to be significantly better than what passive delivers. That is what my AIM Global High Conviction Fund has done since inception, and my team focus on, every single day through all market conditions.
But, after seven years of rising asset prices and an era of unprecedented low interest rates, are we witnessing a “capitulation” into passive products exactly at the wrong time of the cycle?
History suggests money follows performance and that the biggest money flows right at the peak of performance, i.e. right at the wrong time.
In reality, the time to buy passive equity index products was seven years ago, and quite frankly the lift you have had from “Mr Market” from passive strategies has been almost unprecedented in history.
What people seem to conveniently forget, as you do after a sustained period of rising prices, is that passive strategies will also deliver exactly the FALL of the market when it comes. There’s no capital protection in the index itself.
Similarly, correlations are falling inside equity markets and dispersion is increasing, particularly since the Federal Reserve started lifting cash rate and President Trump was elected.
What that means is that a rising index tide is not lifting all ships. The ASX is a classic example where the index is up, but inside that there have been big winners and big losers. If you own the index you own them all: winners and losers.
Perhaps that’s a fine outcome in an overall rising market, but if the market corrects, your passive index fund will also own losers and losers.
My point is buying an “index” that is weighted by current market cap effectively means today, in US equities, you are buying the most expensive group of stocks you could find in the last 17 years as measured by price to sales ratios. They may well get more expensive, but that’s your starting point.
What you need to remember is, price is what you pay, value is what you get (or not). If record amounts of money are pouring into US passive index funds and ETFs on a daily basis, do you think you are buying “value”? No, you’re buying in the hope someone pays more and I don’t think that’s a great strategy other than for short periods.
It genuinely concerns me that “passive” is now a bubble. I almost can’t believe I’m writing that because when indexes were invested, nobody ever thought you’d invest in them. They were designed as a benchmark to beat, not a product to invest in.
Even the Dow Jones Industrial Average is an “average”, where the largest domicile stocks have the largest index weightings. Have you ever wondered why US equities have such large share prices and NOBODY does a stock split? So you can get the biggest weighting in the DOW. The S&P500 is market cap weighted and makes a little more sense, but I stand by my view that indexes were never designed to be an investment product.
Similarly, buying or selling a stock because S&P, MSCI, FT, or whoever changes its weighting in a given index, is something I will never do. It’s ridiculous, and we tend to take the other side of these changes when they happen because they provide contrarian opportunities.
I will never see an index as anything but a benchmark to beat. We, in fact, use index futures to hedge our long investments when we are concerned about protecting our fund from ‘Mr Market’ for periods of time.
In reality, with correlations falling and dispersion rising in equity markets both globally and locally, the “passive bubble” is throwing up more and more opportunities for active stock pickers, both on the long and short-side.
What happens is “passive” chases market capitalisation up and down. Ever wondered how Telstra went from $4.00 to $7.00 to $4.00 without really much changing fundamentally? As its market capitalisation rises, the “passive” and “semi-passive” managers chase the index weight up, and of course vice versa. Hedge Funds and Trader help them along during both phases, exacerbating the price moves.
Often, the single best entry prices at stock specific levels are generated around index down weights. If this is accompanied by a ratings agency downgrade to the given company’s debt, you can be almost assured of a capitulation event.
Remember, EVERYONE who runs money professionally is BENCHMARK AWARE. Australia is probably worse than anywhere with around 200 domestic fund managers trying to beat the most concentrated equity index in the world. In the ASX200, the top 20 stocks represent around 65% of the index. It’s basically banks vs. resources and a couple of retailers and REITS thrown in. It’s an incredibly narrow index for a country that allocated 40% of the 4th biggest pension scheme in the world to domestic equities.
As you’ve seen in stocks like Origin Energy (ORG), BHP Billiton (BHP), Telstra (TLS) and Woolworths (WOW) in recent times, the share price punishment in Australia can be heavy as your index weight falls. This is because even active managers start getting more and more overweight the given stock as its index weight falls.
Too much relative and passive money in Australia chasing too few liquid large cap stocks to generate relative performance. That’s how a pizza company went to a P/E of 60x too!
So at the moment, where are the opportunities on the ASX driven by index changes and asset allocation decisions?
What you need to know is there has been a tonne of money withdrawn from small and mid-cap managers in Australia and reallocated to passive large cap strategies over the last six months. That to me, as a contrarian, would suggest there has been forced transition selling in Australian small and mid-caps. You can see with your own eyes the price falls across the ASX Small Caps sector.
It would also suggest to me that look at large cap “in favour” stocks is not where to find value. If you want to find “value” you need to look at the out of favour.
I would suggest the currently out of favour large cap sectors are telecommunications, discretionary retail, legal, shopping malls, and energy.
The two most beaten up sectors are telecommunications and discretionary retail. The first is on a view that competition is increasingly sharply in voice and data services and these stocks are like commodity stocks with a falling commodity price.
The second is on the view that Amazon is going to destroy traditional bricks and mortar Australian retailers and this, combined with the housing construction cycle peaking, means it’s all over for discretionary retailers.
In telecommunications and discretionary retail, I think the truth will not be as dire as the consensus narrative and pricing rights now. In fact, it’s worth noting short positions have gone through the roof in these sectors, which often coincides with a price bottom. Remember, the financial press (except Peter Switzer), loves publishing a “short story”. This plays a key role in the short-term sentiment.
Where I am getting to today, and I am sorry for rambling as I’m typing this from seat 34k on a Qantas flight from Sydney to Melbourne, is that if you want to be active, start taking advantage of “passive” at extremes.
Remember, I recommended you all QAN at $1.00 and I’ve still got some of the emails! It’s up +300% since. Funnily enough, I just saw Ian Narev, CEO of CBA, also sitting in economy in this flight. How refreshing is it to see a CEO in economy!
Remember again, it wasn’t long ago the world was dumping CBA at $70.00 and short positions were a record.
So instead of putting your money into an index fund at what will prove the top of a “passive bubble”, my advice would be to look to create your own “contrarian ETF” of stocks being dumped by “passive” and “index aware” funds in Australia.
This requires some guts and most likely some patience. However, I believe the chances of generating total returns better than the benchmark are large on a one- to three-year view.
You can all choose your own members of a “contrarian ETF”, but candidates, both large and small cap I would suggest are: Telstra (TLS), TPG Telecom (TPM), Vocus Group (VOC), JB Hi-Fi (JBH), Harvey Norman (HVN), Baby Bunting (BBN), RCG Corporation (RCG), Westfield Group (WFD), Emerchants (EML), Hub 24 (HUB), IPH (IPH), Woolworths (WOW), Brambles (BXB), Healthscope (HSO), Ooh Media (OML), APN Outdoor (APO), Sirtex Medical (SRX), Western Areas (WSA), Independence Group (IGO), Regis Resources (RRL), Kidman Resources (KDR), AMP (AMP) and Platinum Asset Management (PTM).
If nothing else, your portfolio should have a smattering of these stocks. It’s always darkest before the dawn. Remember resources this time last year?
All I know is markets price the present ONLY and passive is playing a major role in that as is high frequency trading.
I believe we are in a massive passive bubble that is providing tremendous contrarian opportunities for active investors. In fact, I’ve never been more ACTIVE!!
There’s two sides to every debate and only in 12, 24 and 36 months will be see if betting against the great wave of passive money will produce excess returns for my investors. So far it has.
You’ll never overtake anyone driving in the same lane.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.
