How LBW Sees It
Macroeconomic factors come in a variety of forms (such as monetary policy, inflation, certain sector performance, etc.) and every so often these factors release their “Kraken”0F potential. And like the “Kraken” you usually don’t realize the monster is right beneath you until it’s swallowing you whole.
Okay, we may have started aggressively by acting as if we are going to make an influential market call1F. Well we aren’t. However, we do want to discuss what we feel resembles a “Kraken” and shed some light on an influential change that is occurring in today’s market – passive investing.
John C. “Jack” Bogle, the founder of Vanguard, created the first index vehicle in 1975, which tracked 500 stocks and is now the Vanguard 500 Index Fund (VFINX). You read that correctly – roughly 42 years ago passive investing was born. Mr. Bogle holds the stance that markets are efficient2F enough that it’s difficult for an active manager to outperform their relative benchmark. Add in extensive fees, and it becomes even more difficult to outperform an unmanaged low-cost index strategy. So, instead of trying to beat the market, he feels you should own the whole thing. Mr. Bogle frequently discusses his approach to investing – simply a 60/40 U.S. allocation3F. He feels rebalancing annually is prudent, and having a long-term approach is crucial. For some of our readers, this may sound familiar; at LBW, we have similar thoughts. For example, if you are NOT going to use a professional who is actively trying to evaluate securities, and investing for the long-term, and you are making contributions and are willing to ride the waves of the market, your next-best alternative is indexing. Our point: we don’t necessarily disagree with Mr. Bogle. We provide similar advice, but we are talking about traditional index investing, which is different from what we are seeing today.
Traditional indexing gained momentum in the mid-1990’s, and since the early to mid-2000’s that pace has accelerated rapidly. For example, in “Looking for Easy Games: How Passive Investing Shapes Active Management”, Credit Suisse stated “Since the end of 2006, investors have withdrawn nearly $1.2 trillion from actively managed U.S. equity mutual funds and have allocated roughly $1.4 trillion to U.S. equity index funds and exchange-traded funds (ETFs).”4F Furthermore, in a January 2017 interview with Business Insider, Mr. Bogle explained “The total market out there is worth $24, $25 trillion dollars, and it’s about 25% owned by indexers”5F. Indexing’s rise to fame, like anything else, has led to innovation in the market, creating vehicles outside of index mutual funds such as Exchange-Traded Funds (ETFs).
An ETF is a pooled vehicle, like that of a mutual fund. However, there is a large difference – ETFs trade intra-day on secondary market exchanges, similar to an individual stock versus a mutual fund that is priced at the end of each day. This new and improved vehicle has cut down costs and allows investors the freedom to exit the fund intra-day if they so choose. ETFs began with the traditional indexing approach, by matching indexes such as the S&P 500, but with every new trend comes rent-seeking activity. ETF’s growth in popularity has expanded into different forms of vehicles such as Smart Beta ETFs, leveraged, double leveraged, and even three times leveraged ETFs – these types of “passive/active” vehicles are not Mr. Bogle’s idea of passive investing. Investopedia defines Smart Beta ETF’s as:
“a type of exchange-traded fund that uses alternative index construction rules instead of the typical cap-weighted index strategy, in a transparent way. It takes into account factors such as size, value and volatility. It utilizes both passive and active methods of investing … passive because it follows an index, but active because it considers alternative factors. Smart Beta ETFs are ideal for investors hoping to maximize their income and returns and minimize risk.”6F
The rise of the “new era” passive/active investment vehicles have helped drive the flows discussed earlier, to passive strategies. So, where is the money going? Mainly three firms, BlackRock, Vanguard and State Street – The Economist article “Stealth Socialism” coined these companies the “Big Three”. And to put their true weight into perspective, in the article they state, “Treated as a single entity, they [BlackRock, Vanguard and State Street] would now be the largest shareholder in just over 40% of listed American firms, which, adjusting for market capitalization, account for nearly 80% of the market.”7F
Now that we have laid out a bit of the history and where the passive investment sector of the market stands, let’s talk about how an index mutual fund works. Let’s take the Vanguard S&P 500 Admiral class (VFIAX) mutual fund for example. The fund tracks the S&P 500 index, which “offers exposure to 500 of the largest U.S. companies, which span many different industries and account for about three-fourths of the U.S. stock market’s value.”8F So, when an individual buys the fund, they are consequently buying every company the S&P 500 tracks, regardless of if it is overpriced, underpriced, going through a potential merger, etc. You get the point – there is no consideration of the companies’ fundamentals. And to take this a step further, if you have continued flows into VFIAX, the price of the companies being bought will see some artificial increase in price, because the index will HAVE to buy them. In Horizon Kinetics’9F July 2016 write up, “Under the hood: What’s in Your Index”, they use ExxonMobil as an example of mispricing due to their exposure to multiple ETFs and index mutual funds. They write:
“Few would argue that the earnings of the oil production industry are not under immense pressure at the moment. As of June 8, 2016, the price of oil has declined by roughly 60% from the prior peak of $120 per barrel in April 2011. The past year has seen a not insignificant number of bankruptcies.
ExxonMobil Corp. has been no exception to that pressure. The company generated peak earnings of $9.70 per share in 2012. In 2015, reported earnings were only $3.85, a decrease of 60% (not coincidentally, matching the movement of overall oil prices).
Yet, here is the most remarkable figure. On the first day of 2012 the ExxonMobil shares closed the day at $85.12 – this was the environment of $100-$120/barrel oil, and the most robust earnings period for oil companies in decades. Would anyone care to guess ExxonMobil’s share price as of June 8, 2016 – $90.78. That’s right, despite a 60% decline in earnings, ExxonMobil actually traded at a higher share price, by 7.1%, than in the beginning of 2012. It’s as if investors believe ExxonMobil is not even an oil company, or at a minimum that the company’s earnings are immune to variations in oil prices, which clearly they are not.
As viewed in this table, the company’s share price demonstrated almost no volatility over that last five years – despite a massive decline in the price of oil, which in and of itself is an extremely volatility commodity. There is, however, one explanation. ExxonMobil is contained in a nearly infinite variety of ETF strategies: energy, dividend-paying, value, large cap, quality dividend, low beta, S&P 500 ex-healthcare, defensive, covered call, to name but a few. It is even a 2.04% weight in the Global X S&P 500 Catholic Values ETF. This link provides all the ETFs with exposure to Exxon Mobil: http://etfdb.com/stock/XOM/”
The timeframe described above is roughly in line with the large, trillion-dollar, shift from active management to passive management we covered earlier. The exposure ExxonMobil has to these vehicles was a large reason for why its price experienced low volatility and even a price increase during a large downturn in the oil markets. And herein lies the problem: what if we experience another 2008 and investors rush out of the market as they did then? We could potentially see a mass exodus from passive equity vehicles into cash or bonds, meaning instead of buying the companies of the index, there will be selling, potentially sending declines even further into the depths. One of the key tenants to an indexing strategy is to ride the wave of the market, but can we trust individual investors to do so? We are not sure we can.
Passive strategies started 42 years ago to allow individual investors access to the broad market at a low cost. Fast forward to today and we have vehicles attempting to mimic the original purpose, but with some flare to obtain more profits. In turn, this has led to a massive shift from active to passive funds during a time where the U.S. market, and the world for that matter, had nowhere to go but up – pushing asset prices higher with zero regard to their true fundamentals. Would you want to buy a home with great curb appeal, but is rotting, stained, and almost unlivable on the inside and to make matters worse, for a premium? Then why would you want to buy a company with the same characteristics? Our point: index investing needs to be placed into context, because if Mr. Bogle’s idea and ideals continue to be distorted, during the next downturn of the market, the “Kraken” may reveal itself sooner rather than later.
When we write How LBW Sees It and Nathaniel’s Beautiful Mind we generally cover separate topics and ideas. However, inadvertently, through our recent readings, we both fell into writing about passive investing and decided we would write about it in both sections. Nathaniel is going to dive further into the nitty gritty and examine some fundamental flaws we see in the structure of indexing, which relates to our more macro view commentary you have just read. Without further ado – welcome to…
Nathaniel’s Beautiful Mind
Mutual Fund Spotlight
Don Yacktman started Yacktman Asset Management LP10F in 1992 after working for Selected Financial Services, Inc. and Stein Roe & Farnham prior to that. Affiliated Managers Group (AMG) bought a majority equity interest in 2012, with the rest split between the four partners. A successful transition took place as Don stepped back and his son Stephen became the Chief Investment Officer in 2013 (Stephen joined the firm in 1993). We like the firm’s comfortability with global ideas, and their “go anywhere” approach looking for investment opportunities both globally and along a company’s capital structure (e.g. common stock, preferred stock, bonds, warrants, rights). We especially like the firm’s Yacktman Focused Fund because it is “non-diversified” and thereby has the capacity to take heavier concentrated positions in its best ideas versus most mutual funds. The Focused Fund’s modus operandi is typically investing in large-cap companies, always paying attention to price versus intrinsic value, willing to hold positions experiencing significant price volatility, and investing with a long-term investing horizon. This is the very definition of a solid value investor in LBW’s book.
Passive Index Investing – Missing the Forest for the Trees
As our clients know, we are active value investors. We research companies, and wait for the market price to decrease versus our estimate of intrinsic value before we buy positions and sell when prices are greater than intrinsic value. Our greatest assets as value investors is the downside protection provided by investing with a margin of safety combined with our long-term investment horizon. The alternative to active investing is passive investing, specifically passive index investing. We won’t go into further detail here as the basics of passive index investing are very well laid out in How LBW Sees It above. What we want to bring to your attention though are a few items that stand out to us about passive index investing. Why? Because there is a lot more beneath the surface than first appears.
Our first topic covers a specific characterization within the S&P 500’s methodology. For our blog post, “What’s Beneath the Covers: The S&P 500 and Dow Jones Industrial Average”11F, we wrote about how the S&P 500 is compiled. One particular point that is pertinent to this quarter’s commentary is that the S&P 500 is “float-adjusted market cap weighted”. What does this mean and why do we deem it important? This phrase has two important pieces to it: the “float-adjusted” and “market cap”. First, “market cap” as we mentioned in our blog post, is a company’s market price multiplied by the number of shares outstanding. As a company’s market cap increases versus the S&P 500, they will move up in weighting and inhabit a bigger portion of the overall index. Further on, we will show how this can be a boon or a problem, situation-dependent. “Float-adjusted” refers to the number of shares outstanding that are available for trading. So, if 40% of a company’s outstanding shares are owned by an insider, like the founder, the company’s weighting in the S&P 500 is calculated using only the shares available for trading. Therefore, only 60% of the company’s outstanding shares would be multiplied by the company’s market price to determine the company’s weighting in the S&P 500. The S&P 500’s methodology actually dictates that any company whose stock does not have at least 50% of its outstanding shares available to trade CANNOT be listed in the index! We strongly believe that one of the best possible sources of high returns rests with companies that have owner-operators at the helm. These owner-operators are typically the company’s founder(s) and have high insider ownership. Ask yourself this: why then would you want to exclude those shares owned by the owner-operator from a company’s market cap calculation if your chances of high returns increase with said owner-operator? If these shares were included in the index, the company’s weighting within the index would be higher, and you as an index shareholder via an S&P 500 index trading vehicle would benefit.
Let’s take a look at the Top 5 S&P 500 positions’, by weighting, performance for the first half of 201712F. Here are a couple of fun facts about the Top 5:
S&P 500’s total market capitalization, in millions: $21,831,524.03
S&P 500’s total float-adjusted market capitalization13F, in millions: $20,796,808.00
This is the statistic that all S&P 500 weightings are based upon. Also note the $1,034,716.03 difference between the total market capitalization and the total float-adjusted market capitalization. That means that over $1T of the S&P 500 is held by insiders and does not apply to their respective company’s weighting within the index!
The largest constituent, Apple has a weighting of 3.6%.
The Top 5 constituents have a total weighting of 11.4%. These constituents include, in descending order of weighting: Apple (AAPL), Microsoft (MSFT), Amazon (AMZN), Facebook (FB), and Johnson & Johnson (JNJ).
Three of the Top 5 are in the Information Technology sector: Apple, Microsoft, and Facebook (we’ll come back to this statistic later).
The Top 5 contributed ~22% of the S&P 500’s 8.24%14F performance for the first half of 2017.
Digest this for a moment. Five companies out of 500 contribute over 20% of the S&P 500’s 8.24% performance for the first half of 2017. This means that the other 495 are contributing the inverse (~78%)!! That’s it! Here is what the Top 5’s returns look like versus the S&P 500’s15F:
Please, make no mistake, we have nothing against concentration. Some of our clients’ portfolios have north of 8-9% in one position, but we have done our research on those positions to feel comfortable with such high weightings, especially with the understanding that we purchase the security at a discount to its intrinsic value. Passive index investors can’t possibly make the same statement. This is because one’s reasoning behind investing in passive index funds is the low expense ratios (due to little to no turnover and no management needed), the elimination of human emotion16F, and the passive vehicle NOT caring about the underlying holdings’ fundamentals.
Our next topic is ETF pricing dislocation versus their underlying holdings and what happens as funds flow in and out. As passive index vehicles experience inflows, the flows filter down to the underlying holdings (e.g. the S&P 500), steadily separating from the fundamentals of the respective companies (remember how we love to talk about price versus value?) as market capitalizations increase. But what happens when flows come out? Forget the index mutual funds for a moment, let’s focus on the index ETFs. ETFs are traded throughout the day versus mutual funds, which are priced at the end of the trading day. Is it not conceivable that throughout the trading day that the price of the ETF could be different than its actual underlying holdings? For example, an ETF and its holdings are both valued the same before the day’s market open. At midday, the ETF’s top-weighted holding, say at 10%, drops by 40% to become a 6% holding (10% x (1-40%) = 6%) due to a poor quarterly earnings report. The ETF compensates by selling 40% of it, and as a result, the ETF drops by 4%.
There are two main issues I want to focus on here: if there is furious trading on a particular holding of the ETF, the ETF has to keep up. What if it’s not the only ETF that holds that company? What if there isn’t enough liquidity in the market? Remember, there is a buyer and a seller in every transaction. For example, if there aren’t enough buyers, and too many sellers, then prices will fall. This actual event happened on August 24, 2014. During pre-market trading hours, the S&P 500 experienced a huge decrease and when the markets officially opened, the pre-market trading had to be immediately accounted for by ETFs that owned the components of the S&P 500. The S&P 500’s and other indices’ decreases were so steep that in some cases the ETFs that owned them experienced price dislocations versus what their holdings were actually trading for. Fortunately, trading halts were triggered and the ETFs’ prices eventually caught back up to their holdings; however, small price dislocations like this happen every day. This leads us to the next main issue, which is the far more important of the two…
Robert Shiller spoke of a concept called the feedback loop in his book Irrational Exuberance. As the news media increasingly reported that stock prices were rising in the late ‘90s and thereby drawing in the public’s attention, new money flowed into the stock market and increased prices further as the public attempted to take advantage of the rising prices. This is the feedback loop. Something similar could occur with ETFs, but in the reverse. First, current, short-term thinking, shareholders of the ETF will see the previously-mentioned 4% price drop and decide to sell their shares. The ETF will sell shares of its holdings to compensate for its outflows. As a result, other ETFs that hold the same company in their portfolios will be forced to sell their holdings to match the decrease in market value caused by the first ETF’s selling. We saw this above, but on a much quicker scale. Now, let’s add an economic recession to the mix as a trigger. Employees with employer-sponsored retirement plans, like 401(k)s, get scared, and stop making contributions to their plans to conserve cash at home and move all of their retirement from those passive equity index holdings to cash. What’s the result? Those inflows into passive index vehicles that have been growing since the financial crisis of ’08-’09 suddenly turn into massive outflows. Price dislocations, as discussed above, on a much larger scale could occur. As people panic and sell their passive equity vehicles, the underlying holdings are losing market value. People panic more, and try and sell their funds faster. At some point, there won’t be enough buyers to handle all the selling. Prices will drop further as buyer demand dries up. Not a pretty picture, right?
Now let’s see what happens when we tie these two concepts together, and let’s look at what could happen when you mix the Top 5 with a bad period of ETF pricing dislocation and feedback loop. For our example, let’s use the companies in the Information Technology sector from the S&P 500’s Top 5: Apple, Microsoft, and Facebook. These three companies have a combined weighting of 7.9%. We will assume that the Information Technology space begins to experience slowing growth, and some companies within the sector have price declines in one day ranging from 5-10% to accompany more reasonable growth assumptions. As markets tend to do, companies experience similar price fluctuations along with their respective sectors. Thus, the three companies’ prices collectively decrease by 10%, and assuming all else is equal within the S&P 500, it experiences a 0.79% performance decline (7.9% x 10% = 0.79%). As it happens, other ETFs that hold any of these three companies must compensate for the price decrease in them as well causing price dislocation between the ETFs and the companies. Trading increases dramatically as ETFs jockey to complete their respective trades and thereby creating a vicious feedback loop. Instead of their collective price decrease for the day being -10%, Apples, Microsoft’s, and Facebook’s losses could end the day -20% with a corresponding loss for the S&P 500 of -1.58%. Let’s not forget the S&P 500 index mutual funds settle at the end of the trading day too, and that -1.58% loss would decrease even more!
We’re not suggesting that there is a passive index bubble by any means. Rather, we wish for you to understand that there is more to passive index investing than initially appears. We encourage you to ask not only us questions, but those around you who advocate passive index investing. As we mention in How LBW Sees It, when utilizing passive investment vehicles, you must be consistent with your strategy, regardless of it being passive or active. You must be willing to ride out the ups and downs in the stock market, and be consistent in your contributions to or withdrawals from your passive index investments.
 Successor to Yacktman Asset Management Co.
 60% U.S. equity index funds equities and 40% U.S. index bond funds.
 LBW follows and utilizes Horizon Kinetics’ mutual fund offerings.
 Successor to Yacktman Asset Management Co.
 Assume for all returns and weightings in this writeup that they are as of 6/30/2017. Source: http://us.spindices.com/indices/equity/sp-500: see Factsheet button -> Month-End
 Siblis Research: http://siblisresearch.com/data/total-market-cap-sp-500/
 http://us.spindices.com/indices/equity/sp-500: 8.24% capital appreciation + 1.10% dividends = 9.34% total return
 Wall Street Journal
 Remember though, humans maintain the S&P 500. Please see our S&P 500 blog post
“What’s Beneath the Covers: The S&P 500 and Dow Jones Industrial Average”
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