PASSIVE VS. ACTIVE MANAGEMENT (PART III)

Transcription

1 PASSIVE VS. ACTIVE MANAGEMENT (PART III) Sandy McIntyre, Executive Vice-Chairman and Director Exchange-traded funds () continue to enjoy tremendous popularity with investors. But how do they stack up against actively managed funds? In this third instalment of a series of articles titled Passive vs. active management, Sandy McIntyre continues to explore the answers to this question. If you are interested in reading his first two instalments, you can find them on sentry.ca. The money flow into and low-cost mutual funds has turned into a flood over the past year. An article in the Wall Street Journal on February 24th of this year gives one perspective on this trend: How Dangerous Is a Stock Market of Mindless Robots? The article provides some fascinating statistics: Four leading robo-advisors Betterment, Schwab Intelligent Portfolios, Vanguard Portfolio Advisory Services and Wealthfront have roughly doubled their assets in the past year, to $77 billion. In 2016, 85% of new retail investments coming through financial advisors (more than $600 billion) went into index funds and, according to Broadridge Financial Solutions, which helps process such trading. When you look at the money flow for the U.S., the trend is relentless. According to a study that we did here at Sentry, the top 30 mutual fund companies in the U.S. had combined inflows of $441.3 billion for the year ending in March. The top inflows were to Vanguard, a renowned index mutual fund manager: $322.1 billion. Excluding Vanguard, the other 29 fund complexes had inflows of $119.2 billion. Over the one-year period, active management had outflows of $309.6 billion while passive had inflows of $637.9 billion. Sentry Investments Passive vs. active management (Part III) 1

2 The Investment Companies Institute provides longer-term data on this trend. Since the beginning of 2007, the ETF industry has attracted $1.967 trillion in net subscriptions while the mutual fund industry has had net subscriptions of $884 billion. The two data series moved in tandem until Q Since then, the ETF series has accelerated while the mutual fund series has moved into redemption. have dominated the market since 2014 Cumulative Total Mutual Fund NNCFTTEW Index 884,439 Source: Investment Companies Institute; Bloomberg L.P.; Sentry Investments. As of May 3, Sentry Investments Passive vs. active management (Part III) 2

3 When you look into the flows, you find that the total flows of $2.851 trillion are broken down into $0.824 trillion equity (-$679 billion mutual fund; +$1.503 billion ETF), $1.841 trillion fixed income (+$1.384 billion mutual fund; +$457 billion ETF) and $185 billion hybrid funds. Equities: dominated by passive investments () Cumulative Total Equity MF NNCFTEEW Index (679,255) Cumulative Total Equity ETF HXTFNIET Index 1,503,315 Source: Investment Companies Institute; Bloomberg L.P.; Sentry Investments. As of May 3, Fixed income: dominated by active investments (mutual funds) Cumulative Total Bond ETF HXTFNITB Index 456,892 Cumulative Total Bond MF NNCFTBEW Index 1,384,450 Source: Investment Companies Institute; Bloomberg L.P.; Sentry Investments. As of May 3, Sentry Investments Passive vs. active management (Part III) 3

4 Note that all the net mutual fund flows are to fixed income. Within fixed income, the majority of the flows are into investment-grade funds. The equity flows domestically are primarily into passive products within both the U.S. mutual fund and ETF complexes; Blackrock, Vanguard and State Street are dominating the activity with 84% of the assets and 76% of January s subscriptions. In Canada, the order is Blackrock, BMO and Vanguard with 85% of the assets and 57% of April s flows. When you look at U.S. domestic equity, the mutual fund outflows exceed the ETF inflows: no net new money into the asset class from fund buyers. Equities: mutual fund outflows greater than ETF inflows Cumulative Domestic Equity Mutual Fund NNCFDEEW Index (1,172,517) Cumulative Domestic Equity ETF HXTFNIDE Index 980,203 Source: Investment Companies Institute; Bloomberg L.P.; Sentry Investments. As of May 3, Sentry Investments Passive vs. active management (Part III) 4

5 Many factors help stock selection I do not have good access to data that breaks down ETF assets and flows by primary strategy: passive, factor/smart beta or active. Eyeballing Canadian data indicates to me that the majority of the flows are into the passive category with rising amounts into factor/smart beta. Active are still a very minor part of the industry. We did a study where we looked at the performance of popular factors over the past 15 years to see if there were factors that helped stock selection. No single investment factor dominates year after year Source: Morningstar, data as at December 31, Dividend = S&P 500 Dividend Aristocrats TR USD; Quality = S&P 500 Quality TR USD; Low Vol. = S&P 500 Low Volatility TR USD; Momentum = S&P 500 Momentum TR USD; Value = S&P 500 Value TR USD; High Beta = S&P 500 High Beta TR USD Bloomberg L.P., data as at December 31, The rankings were as follows: Dividend payers with a 15-year annual return of 9.7%, Quality: 9.2%, Low volatility: 9.1%, Momentum: 7.2%, the S&P 500 Index: 6.7%, Value: 6.7% and High beta: 3.8%. The reason they are ranked by year is because no one factor works year over year. Over the 15-year period, Dividend payers never ranked first and ranked last in 2007 as the last bull market was ending. While High beta ranked first six times (40% of occurrences) including 2016, it also ranked last five times; over the long term, it ranked in last place. Low volatility was first five times and last four times. It is not unusual to have High beta and Low volatility at opposite ends of the league table. As money flows into and out of these factors, there are bound to be distortions. It should be noted that none of these strategies is pure. There are also issues with concentration as various strategies overlap. The following comparisons are as of March 27, S&P 500 Growth Value Dividend Quality Pro-weighted Index PE 30.0xs 32.7xs 26.9xs 23.8xs 27.7xs Top 25 weight 33.6% 43.6% 40.8% 49.1% 64.6% Top 25 PE 32.8xs 34.6% 27.7xs 26.6xs 21.8xs There is a fair amount of overlap between the strategies; 46% of the Growth names overlap with Value, but by weight, they represent only 30%. Value has 41% of its names overlap with Growth, 27.8% by weight. The overlaps in the top 25 are more modest; Growth has a 20% overlap in the top 25 while Value has a 17% overlap. These are clearly not pure strategies. The Dividend payers overlap with Growth is 30 of 51 names weighing 59.4%. The Dividend payers overlap with Value is 36 names and 70.4% by weight. Sentry Investments Passive vs. active management (Part III) 5

6 Investors are looking for low volatility Going into mid-year 2016, the most popular strategy was Low volatility (winning factor in 2014 and second in 2015). The largest low-volatility fund is the ishares MSCI Ultra Low Volatility U.S. Equity ETF (ticker USMV). From August 1, 2015 to July 31, 2016, that fund attracted $8.5 billion in new capital, increasing the size of the fund by 161%. From the peak in popularity of the strategy in July, the fund has shed $3.2 billion in assets (20.4% of the late July capitalization). What did the extreme flows in this fairly narrow factor do to valuations? What did the flows do to volatility characteristics? Source: Bloomberg L.P.; Sentry Investments Between June 2015 and July 2016, the volatility for the market (using mean 30-day volatility, this is realized volatility, quite different from the VIX) increased from to The sectors that were meaningfully overweight in the USMV are highlighted in yellow. Larger sectors with overweights like consumer staples and health care likely had their own unique reasons for diverging from index trend. Staples started with abnormally low volatility which subsequently rose to fall more in line with the market. Health care was already being affected by the U.S. presidential campaign in 2015 and had heightened volatility that continued into Materials was an unusual overweight that was corrected during the period, likely due to a sharp increase in volatility. Where there is an unusual affect that is likely attributable to low-volatility flows is in small sectors like real estate and utilities. Volatility collapsed and like consumer staples, valuations increased sharply much more than just the market effect. The flows turned on July 26, When you look at the post-july analytics, again you can see some sector affects. Source: Bloomberg L.P.; Sentry Investments Sentry Investments Passive vs. active management (Part III) 6

7 Again you have the meaningful over-weights highlighted in yellow. From July 26, 2016 to March 28, 2017, the S&P 500 was up 8.7%. Volatility collapsed: -45%. Valuations increased for the index by 7%. Staples, health care, real estate, telecom and utilities all failed to participate in the valuation lift. Each had declines in volatility but not to the same degree as the market. Indeed I think you could say that the low-volatility characteristics desired by investors have largely disappeared as money flow flooded into and out of narrow sectors. In order to get a sense of the strategy overlaps, Sentry downloaded the portfolios of Factor that are based on Standard & Poor s indices as of June 30, 2015, July 29, 2016 and year end Getting into some of the narrower factors, you find that each of the PowerShares S&P 500 Low Volatility (SPLV), the PowerShares S&P 500 Quality (SPHQ), Powershares S&P 500 Momentum (SPMO) and ProShares Dividend Aristocrats (NOBL) portfolios each had 100 positions. The Momentum portfolio started in the autumn of When we looked at the cross-portfolio overlaps, we came up with the following table: Dec-15 Jul-16 Mar-17 # of Holdings % of Portfolio # of Holdings % of Portfolio # of Holdings % of Portfolio PowerShares S&P 500 Quality Securities that overlap in any of the 4 Securities that overlap in ALL % % % 7 5.6% 4 4.7% 4 3.4% Total securities within ETF % % % PowerShares S&P 500 Low Vol PowerShares S&P 500 Momentum Securities that overlap in any of the 4 Securities that overlap in ALL % % % 7 7.2% 4 4.0% 4 3.8% Total securities within ETF % % % Securities that overlap in any of the 4 Securities that overlap in ALL % % % 7 2.6% 4 4.0% 4 3.4% Total securities within ETF % % % Proshares Dividend Aristocrats Securities that overlap in any of the 4 Securities that overlap in ALL % % % % 4 7.8% 4 7.8% Total securities within ETF % % % Source: Bloomberg L.P.; Sentry Investments Sentry Investments Passive vs. active management (Part III) 7

8 I think it is reasonable to expect that, with the degree of overlap in various simple factor-based strategies, performance and volatility will converge. Indeed that is what was happening until the overlap between Momentum and Low volatility began to unwind: Low volatility was tracking Quality until the outflows began in Q3 last year outflows that were magnified by Momentum selling down its Low volatility exposure. Sentry Investments Passive vs. active management (Part III) 8

9 Be wary of chasing themes I have long believed that chasing themes is a lazy substitute for sound portfolio management. The greatest disservice the industry and the media have done to end investors is to create the expectation that their portfolios should outperform some benchmark a benchmark that may have very different risk characteristics from the risk tolerance of the investor. I would never benchmark invest in Canada. In the U.S., there are periods where I would benchmark invest; however, there are parts of the cycle when benchmark investing is dangerous. We may well be approaching one of those periods; market leadership is narrow and dominated by thematic investing: the FAANGGs (Facebook, Amazon, Apple, NetFlix, Alphabet, Google and their satellite companies). Yet again, new valuation paradigms are being advanced. Corporate leverage is rising as companies borrow to buy back shares and pay dividends. While the market is not cheap, it is bifurcated. The top 10 companies are in aggregate expensive: S&P 500 INDEX Ticker Name May 10, 2017 May 10, 2017 AAPL UW Equity Apple Inc MSFT UW Equity Microsoft Corp AMZN UW Equity Amazon.com Inc FB UW Equity Facebook Inc XOM UN Equity Exxon Mobil Corp JNJ UN Equity Johnson & Johnson JPM UN Equity JPMorgan Chase & Co BRK/B UN Equity Berkshire Hathaway Inc GOOGL UW Equity Alphabet Inc GOOG UW Equity Alphabet Inc Top S&P Source: Bloomberg L.P.; Sentry Investments Sentry Investments Passive vs. active management (Part III) 9

10 Concentration is nowhere like the bubble in 2000, but it is worth looking at how the top 10 fared following past frothy market peaks. The S&P 500 peaked on March 24, The top 10 on a weighted-average basis are still under water 17 years later. The spread to the index? -6.9%. Five of the positions have not recovered to their 2000 values: Ticker Name S&P 500 INDEX Mar 24, 2000 Mar 24,2000 Apr 28,2017 Break Even Compound Annual Return to April 28, 2017 MSFT US Equity Microsoft Corp % CSCO US Equity Cisco Systems Inc NA -3.9% GE US Equity General Electric Co NA -0.5% INTC US Equity Intel Corp NA -1.6% XOM US Equity Exxon Mobil Corp % WMT US Equity Wal-Mart Stores Inc % ORCL US Equity Oracle Corp % IBM US Equity International Business Machines Corp % LU US Equity Alcatel-Lucent USA Inc (AQUIRED 2006) NA NA -21.1% NRTLQ US Equity Nortel Networks Corp NA NA -23.7% Top NA -1.9% S&P % Source: Sentry Investments; Bloomberg L.P. Source: Sentry Investments; Bloomberg L.P. The NASDAQ Composite is even more extreme; only three positions have fully recovered. In aggregate, the top 10 have underperformed the index by 5.3% annually: Ticker Name NASDAQ COMPOSITE INDEX Mar 10, 2000 Mar 10, 2000 Apr 28,2017 Break Even Compound Annual Return to April 28, 2017 MSFT US Equity Microsoft Corp % CSCO US Equity Cisco Systems Inc NA -3.9% INTC US Equity Intel Corp NA -1.6% ORCL US Equity Oracle Corp % JAVA US Equity Sun Microsystems Inc NA NA -16.1% WCOM US Equity WorldCom Inc (Aquired 2002) 2.1 NA NA NA -23.7% DELL US Equity Dell Inc (Aquired 20132) NA NA -7.4% YHOO US Equity Yahoo! Inc NA -3.5% QCOM US Equity QUALCOMM Inc % AMAT US Equity Applied Materials Inc NA -5.2% Top NA -3.2% CCMP Index NASDAQ Composite Index % Source: Sentry Investments; Bloomberg L.P. Source: Sentry Investments; Bloomberg L.P. Sentry Investments Passive vs. active management (Part III) 10

11 Just for fun I took a look at the S&P/TSX post the June 18, 2008 peak. Three of ten positions (all banks) have recovered; in aggregate, the top 10 underperformed the index by 6.7% per annum. They represented 38.3% of your capital in a passive strategy and close to that in a fund that was closet benchmarking. Ticker Name S&P/TSX COMPOSITE INDEX Jun 18, 2008 Jun 18, 2008 Apr 28,2017 Break Even Compound Annual Return to May 1, 2017 POT CN Equity Potash Corp of Saskatchewan Inc NA -11.2% ECA CN Equity Encana Corp NA -10.2% BB CN Equity BlackBerry Ltd NA NA -24.5% RY CN Equity Royal Bank of Canada % SU CN Equity Suncor Energy Inc NA -2.2% CNQ CN Equity Canadian Natural Resources Ltd NA NA -0.1% MFC CN Equity Manulife Financial Corp NA -1.5% TD CN Equity Toronto-Dominion Bank/The % BNS CN Equity Bank of Nova Scotia/The % ABX CN Equity Barrick Gold Corp NA -5.2% Top NA -2.9% SPTSX Index S&P/TSX Composite % Source: Sentry Investments; Bloomberg L.P. Source: Sentry Investments; Bloomberg L.P. Running with the herd can be dangerous This raises a very interesting question: Is moving to a passive strategy in a mature market cycle a good strategy? Being wrong in a market with narrow leadership that is also an expensive market is the right time to be wrong. You are choosing not to speculate on when the music stops. Investors see popular names generating what they believe to be low-risk profits, and feel they are being misled by their advisors when they are not participating in these gains. This is Mr. Bean investing: jealously imitating others. Being wrong early cycle when there is broad market leadership means you are sitting on the sidelines in cash because it is too risky. This is Turtle or Bunker investing. Both are symptoms of a common human failing: the persistence of perception. You take recent experience and extrapolate it into the future. Following trends works until it doesn t. If it worked well, Momentum would be the most successful style box in our factor quilt. It isn t. I don t know why it is so popular. I guess it is because there is comfort running with the herd. But if you are running with them, stay close to the edges. You don t want to be carried into danger. In my parlance, Momentum investing is farm yard dog investing; you chase whatever is running and when it stops, you get run over. Sentry Investments Passive vs. active management (Part III) 11

12 are not passive; and they are not necessarily cheap Early in my career I had a Chief Investment Officer who made a very wise comment to me: Sandy, every investment decision you make is binary: you will be right or you will be wrong. The more rapidly you sequence decisions, the greater the risk you make a series of wrong decisions. Make sure the first decision you make is right. Don Cameron, CIO, Jones Heward Investment Management give you inexpensive exposures to factors, sectors, asset classes, geographies, etc. Each time you choose to change your exposures, you are making an active investment decision. The indices the vast majority of ETF providers use are also active. Index committees add and subtract members regularly. Some indices include too many members to replicate; the ETF manufacturer who chooses these indices attempts to replicate the exposures using a much smaller sub-set of index members. This is active management. Finally there is the liquidity mechanism. When you buy or sell an ETF, it is always priced in reference to its net asset value (NAV). The belief system is the liquidity providers (usually arbitrage desks at large investment banks) keep the price tight to NAV. Are they charitable organizations that do this for minimal compensation? I doubt it. Is there a conflict of interest if the ETF manufacturer is also a liquidity agent? Absolutely. In my first ETF article I explored this theme in detail. I have read articles that suggest the spreads earned on making and breaking ETF units exceed the management fees earned by the ETF manufacturers by as much as one third. When markets are fast, the arbitrageurs back off, spreads to NAV widen and liquidity evaporates. Remember August 24, 2015, the day the circuit breakers broke on the New York Stock Exchange? The result was costly for those who accessed the low-cost liquidity of : NOTE: The reason there is no change to the S&P 500 Low Volatility Index at the open and high for August 24th is the index was unable to strike a value at those points of the day. Source: Bloomberg L.P.; Sentry Investments Sentry Investments Passive vs. active management (Part III) 12

13 I quote from that article: The opening trades were almost blind; circuit breakers had kicked in on a number of index components which made the arbitrage algorithms used by the broker dealer ETF market makers useless. By early afternoon, when the high for the day was established, the abnormal spreads had largely been eliminated. A resumed downtrend in the afternoon ended around 3:30, again with wide spreads between ETF and index valuations. Continued negative intraday volatility turned circuit breakers on and off resulting in real price dislocations in higher-volatility markets: NASDAQ and strangely in the PowerShares S&P 500 Low Volatility ETF (SPLV). SPLV ended the day down 5.3% versus its reference index, which was down 1.5%. What cannot be determined is whether or not capital requirements on the trading/arbitrage desks of the broker dealers also contributed to the failure of the price arbitrage algorithms to maintain a reasonable spread between the value of the ETF units and the underlying components. If the 42% of August 24th trading volume was in and a large part of ETF volume is through the arbitrage desks making and breaking ETF units, then did the arbitrage desks become capital constrained during a rapid market decline? We do not know. To me the primary risk with is that we are herding into an investment innovation that promises inexpensive fees and second-by-second liquidity. What happens when the herd thunders the other way? What will the cost be for accessing second-by-second liquidity? Concerns about fee friction are legitimate and it is up to our industry to provide an effective solution. But in my view, liquidity should always be at intrinsic value of the investors proportionate share of the portfolio they are participating in. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. Certain statements in this document are forward-looking. Forward-looking statements ( FLS ) are statements that are predictive in nature, depend upon or refer to future events or conditions, or that include words such as may, will, should, could, expect, anticipate, intend, plan, believe, or estimate, or other similar expressions. Statements that look forward in time or include anything other than historical information are subject to risks and uncertainties, and actual results, actions or events could differ materially from those set forth in the FLS. FLS are not guarantees of future performance and are by their nature based on numerous assumptions. Although the FLS contained herein are based upon what Sentry Investments and the portfolio manager believe to be reasonable assumptions, neither Sentry Investments nor the portfolio manager can assure that actual results will be consistent with these FLS. The reader is cautioned to consider the FLS carefully and not to place undue reliance on FLS. Unless required by applicable law, it is not undertaken, and specifically disclaimed that there is any intention or obligation to update or revise FLS, whether as a result of new information, future events or otherwise. Sentry, Sentry Investments, the Sentry Investments logo and Calmly create wealth are trademarks of Sentry Investments Corp _COM_SM (07/17) E Sentry Investments Passive vs. active management (Part III) 13