The Hidden Costs of Passive Investing

Transcription

1 The Hidden Costs of Passive Investing Index Funds and ETFs: Increasing Risk in a Changing Market January 2018

2 Wintergreen Advisers, LLC ( Wintergreen or we ) provides investment advisory services to multiple clients, including pooled investment vehicles and a registered investment company, Wintergreen Fund, Inc. (the Fund ). The views contained in these materials are those of Wintergreen as of January 8, 2018, and may not reflect its views on the date these materials are first published or anytime thereafter. Any examples of specific investments are included to illustrate Wintergreen s investment process and strategy for investing the assets of its clients, including the Fund. There can be no assurance that such investments will remain represented in a portfolio. Holdings and allocations are subject to risks and to change. The views described herein do not constitute investment advice, are not a guarantee of future performance, and are not intended as an offer or solicitation with respect to the purchase or sale of any security. Mutual fund investing involves risks, including loss of principal. Investors should consider the investment objective, risks, charges and expenses of the Fund carefully before investing. The Fund is subject to several risks, any of which could cause an investor to lose money. Please review the prospectus of the Fund for a complete discussion of the Fund s risks which include, but are not limited to: possible loss of principal amount invested; stock market risk; value risk; interest rate risk; income risk; credit risk; foreign securities risks, including currency risk and emerging market risk; derivatives risk; short sale risk and investor activism risk. Wintergreen follows a global value approach to investing the Fund s assets. The Fund s investments in foreign securities exposes the Fund to risks associated with currency fluctuations, economic or financial instability, lack of timely or reliable financial information or unfavorable political or legal developments, which risks are magnified in emerging markets. In light of these risks, the Fund may not be suitable for all investors. The prospectus, which contains this and other information about the Fund, may be obtained by contacting the Fund, free of charge, by telephone at (888) GOTOGREEN ( ), or by visiting the Fund s website at The prospectus should be read carefully before investing. Page 2

3 What s Best For Investors The winds of the stock market are changing, making for challenging times for both institutional and individual investors. Many see the market as overpriced and overheated with gains over the past few years driven by market momentum. We believe this momentum has been further fed by huge inflows to index funds, which are then obligated to buy more of the biggest momentum stocks, without regard for valuation. Page 3

4 On the Index Bubble This momentum cycle has created a dangerous bubble where the risk-return ratio has become untenable for investors. Market corrections will likely expose liquidity issues around index funds and ETFs, causing pain for their investors. Because they are seen as low cost, assets have flowed into index funds and ETFs. Page 4

5 Blind Rush to Passive $600,000,000 U.S. Passive vs. Active Fund Flows $500,000,000 $400,000,000 $300,000,000 $200,000,000 $100,000,000 $0 ($100,000,000) ($200,000,000) ($300,000,000) ($400,000,000) PassiveFlow $217,000,000 $215,000,000 $193,000,000 $195,000,000 $195,000,000 $259,000,000 $305,000,000 $420,142,000 $412,822,000 $504,776,000 ActiveFlow $185,000,000 ($195,000,000) $275,000,000 $190,000,000 $15,000,000 $203,000,000 $115,000,000 $44,265,000 ($206,681,000) ($340,137,000) Passive Flow ActiveFlow Flows by Year: Active v. Passive ($million), (source: Morningstar Asset Flow Reports) Page 5

6 Best Laid Plans Gone Awry Index funds began as a good idea offering diversification at low costs. This was meant to drive value for investors while reducing overall risk. But these passive funds have ballooned to over $3T in assets, and we believe these products have become momentum monsters and present liquidity issues. Page 6

7 Best Laid Plans Gone Awry Index funds put stress on the markets with high concentrations of securities with lofty valuations. ERISA s (Employee Retirement Income Security Act of 1974) recognition of the proxy vote as an important element of the value of a security is being largely neglected. Page 7

8 Best Laid Plans Gone Awry 97% of the time, index funds vote in favor of management proposals, creating increased hidden costs for investors*. *Based on proxy voting by Vanguard, State Street and Blackrock for the year ending June 30, 2016 Page 8

9 Hidden in the Fine Print We believe index funds and ETFs touting low expenses are often providing incomplete and misleading information, with investors unknowingly exposed to other hidden costs. This overwhelming approval of compensation plans creates value dilution that we have shown far outweighs low fund management fees. Page 9

10 We believe that index funds and ETFs are risky and will be compromised, ultimately costing investors long-term gains due to three key reasons. Page 10

11 Three Risks of Index Funds and ETFs 1. Hidden costs in index funds and ETFs significantly reduce returns. We call these Look Through Expenses. 2. Market weight cap index funds and ETFs are concentrated and create self-fulfilling momentum strategies that artificially inflate valuations of stocks. 3. Index funds vote in favor of management recommendations virtually all the time, which leads to increased costs to investors. Page 11

12 Risk #1: Hidden costs in index funds and ETFs Hidden costs in index funds and ETFs significantly reduce returns. We call these Look Through Expenses. Page 12

13 Look-Through Expenses: What Are They? People who invest in index funds and ETFs believe their expenses are much lower than other investment vehicles, but hidden costs significantly reduce the returns of these funds. They are: Dilution from executive stock compensation plans. Company shares issued annually for executive compensation are a major component in Look Through Expenses. Buybacks to offset dilution created by executive stock option plans. Ongoing corporate share buybacks to offset executive stock option dilution also increase these expenses. Data from 2016 proxies and annual reports. Graphic source: Economic Policy Institute Page 13

14 Wintergreen s Methodology Wintergreen analyzed the Proxy Filings and Annual Reports for each of the companies in the S&P 500. We calculated the dilution from executive stock compensation plans. Care was taken to focus specifically on the Named Executive Officers and to not include shares granted to other employees. We then calculated the Buybacks being used to offset dilution created by executive stock option plans. Data from 2016 proxies and annual reports Page 14

15 Wintergreen s Methodology Amazon Example Dilution: From page 36 of the 2017 Amazon proxy statement, it is disclosed that Amazon has 19.8m shares to be issued upon the exercise of outstanding options, warrants and rights for executive compensation awards and 123.1m total additional shares authorized under executive compensation plans that are available for future issuance under management compensation plans, for a total of 142.9m executive compensation shares Page 1 of the proxy shows 477m total shares outstanding for the company. When the 142.9m total possible executive compensation shares are divided by these 477m shares the resulting Total Dilution is 30.0% Page 27 of the 2017 proxy notes a term of 5.5 years for the executive bonus plan, which results in average annual dilution of 5.4% Source: 2017 Amazon Proxy Statement Page 15

16 Wintergreen s Methodology Amazon Example Buyback: Amazon had no buybacks in 2013, 2014, 2015, With 472m shares outstanding, the average annual buyback is 0.0% Amazon s total look through expense to shareholders (average dilution plus average buyback used to offset executive compensation) is an annual 5.4% Wintergreen conducted this research for EVERY company in the S&P 500 Source: 2017 Amazon Proxy Statement Page 16

17 The Real Cost of An Index Fund to Shareholders From the Index Fund s Prospectuses What You Think You Pay 0.04% Calculated from the Company s Proxy Filing Dilution from Compensation 2.6% Calculated from the Company s Annual Report Buybacks to Offset Dilution 1.7% 4.3% * AVERAGE 2016 LOOK-THROUGH EXPENSES FOR S&P 500 * Data as of 2016, based on Wintergreen s analysis of dilution due to executive bonus plans and buybacks used to offset that dilution. Average fees of leading S&P 500 Index Funds. Please see for more information. Page 17

18 Real Costs in the SPY ETF Advertised Management Fee 0.095% Look-Through Expense * including Advertised Management Fee 4.325%* Market Maker Spread 0.149% Arbitrage Spread 0.011% Creation Fees Market Maker Spread = 1yr turnover % * average spread % Arbitrage Spread = $equalized net income / $total net assets Creation Fees = ((#units * $unit fee)/unit size) / $total net assets % Total: 4.62% 49 times more costly than advertised! * Data as of 2016, based on Wintergreen s analysis of dilution due to executive bonus plans and buybacks used to offset that dilution. SPY ETF data from 2016 SPY ETF Annual Report. Please see for more information. Page 18

19 Huge Costs to Investors Over Time. Long-term investment returns will suffer due to Look-Through Expenses. Look-Through Expenses of 4.3% may seem small now..but if these LTEs compound annually at 6%, the effect on your returns would be staggering increasing to almost 25% by year 30! Look-Through Expense of 4.1% in 2015 compounding at 6% (EPI, CEO Pay Rises as Typical Workers Are Less, Issue Brief#380, June 2014.) Page 19

20 The Long-Term Impact of Look-Through Expenses on Returns This hypothetical chart shows what could happen to $100,000 invested over 30 years. Effect of Look-Through Expenses on Return If markets compound at 6% annually, which is a common prediction of leading index funds, the added effect of Look-Through Expenses over the long term can be staggering. As suggested by the Economic Policy Institute*, Look-Through Expenses are also expected to compound at 6%. This example shows that if Look-Through Expenses did not exist, investor returns would have been much higher. Each year s hypothetical return has been calculated based on 6% market growth, which is based on an S$P 500 index fund s sales material. What You Could Have Made shows what you could have made if the compounding Look-Through Expenses had not been deducted from each year s return. Effect of Look-Through Expenses on Returns *Look-Through Expenses of 4.1% in 2015 compounding at 6% (Economic Policy Institute, CEO Pay Rises as Typical Workers Are Less, Issue Brief #380, June Washington, DC.) Portfolio Value (Thousands) $1000 $900 $800 $700 $600 $500 $400 $300 $200 Portfolio return before LTE ( What you could have made ) Portfolio return after LTE ( What index funds predict you will make ) $ $898,487 $574,349 Page 20

21 Price-Earnings Ratio (CAPE, P/E 10) CAPE Price E10 Ratio x x Highest P/E in history Except for 1929 and 2000! 32.3x* Price-Earnings Ratio (CAPE, P/E 10) Risk #2: Market Weighting = Concentration of Returns Index Funds and ETFs are Concentrated and Laden with Risk Average * As of December 1, 2017 Source: Page 21

22 Blind Rush to Passive Data: Pictet, Morningstar

23 The Diversification Myth: FANG and Friends 70% FANG & Friends: Average Total Return 75% of the time, these 10 stocks have driven stock market performance 60% 50% 40% 30% 20% 10% 0% -10% FANG & Friends 32.71% 0.70% 34.72% 63.42% 7.50% 45.97% 5.86% 42.12% Rest of S&P % 0.37% 16.02% 34.62% 13.67% -2.37% 13.66% 17.22% S&P 500 Average 19.46% 0.37% 16.34% 35.17% 13.54% -1.38% 13.50% 21.76% FANG and Friends: Alphabet, Amazon, Apple, ebay, Facebook, Microsoft, Netflix, Priceline, Salesforce, and Starbucks. Through December31, 2017 Page 23

24 The Liquidity Myth: August 24, 2015 We believe the dangers of ETFs became apparent on August 24, 2015, a day when volatility kept about half of the stocks in the S&P 500 from opening on time. As a result, pricing for some of the most popular S&P 500 index products broke down. J.P. Morgan estimates that 290 ETFs traded at apparently wrong prices in the first hour of trading and led to investor losses of $250 million. J.P. Morgan Market and Volatility Commentary, September 24, Page 24

25 Record Levels of Margin Debt Source: New York Stock Exchange, Margin Debt Data Page 25

26 Record Levels of Margin Debt Robert Kaplan President and CEO, Federal Reserve Bank of Dallas I would also note that margin debt is now at record levels. In the event of a sell-off, high levels of margin debt can encourage additional selling, which could, in turn, lead to a more rapid tightening of financial conditions. * *November 27, 2017, A Balanced Approach to Monetary Policy Page 26

27 When Active Funds Are Not Active The majority of active managers have given up trying to outperform the index and have realigned their strategies to mimic indexes. We call this index light. With so much capital either in passive funds or index light funds, we think the risk of a bubble bursting is more prevalent than ever. When the tide goes out, we believe the high risks of index funds and high R 2 investment portfolios will damage the savings and retirement accounts of many. Page 27

28 How to Tell if Your Manager is Really Active Fund Name Ticker R-Squared S&P 500 Index SPY Hartford International Fund HILAX Oakmark Fund OAKMX Franklin Mutual Shares Fund MUTHX Dodge & Cox Global Stock Fund DODWX Artisan Global Value ARTGX Wintergreen Fund WGRIX Source: Bloomberg as of 12/31/2017 Page 28

29 Investors Beware: Total Expenses Can Diminish Your Returns Greatly True Active Managers Can Make Investments in Securities with Lower Look Through Expenses Mutual Fund Side by Side Comparison: Estimated Total Expenses to Shareholders State Street SSJIX 0.85% 4.46% Blackrock MALVX 0.87% 4.78% Vanguard VWUSX 0.46% 4.45% Wintergreen WGRIX 1.70% 2.59% 0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% Advertised Net Expense Ratio Total Expenses to Shareholders* *Total Expenses to Shareholders = (AVG LTE x R 2 ) + Net Expense Ratio Look Through Expense data as of 2016, based on Wintergreen s analysis of dilution due to executive bonus plans and buybacks used to offset that dilution. Expense Ratios from 2017 prospectuses. Page 29

30 Risk #3: Weak Corporate Governance Investors Don t Realize the Impact of Weak Governance on Hidden Costs Page 30

31 Weak Corporate Governance Costs Billions Index Funds and ETFs seem to overlook fiduciary responsibility to look out for investors financial interests, ignoring Look-Through Expenses. Wintergreen s Calculation of Look Through Expenses is the Total Amount that Company s have the ability to award to executives without the need for any additional shareholder approval or regulatory input. Although Congress initially authorized $700 billion for TARP in October 2008, that authority was reduced to $475 billion by the Dodd-Frank Act. Look- Through Expenses are an ongoing annual expense; data calculated as of Source: Page 31

32 Weak Corporate Governance Costs Billions The societal impact is staggering - the potential of $908 billion of Look Through Expenses is equal to 4.9% of the United States GDP. Potential dollar amounts for LTE: $475 Billion TARP in 2008 A one-time expense $828 Billion Look-Through Expenses in 2015 About equal to the 17th largest economy in the world (Turkey) Potential ongoing annual expense $908 Billion Look-Through Expenses in 2016 About equal to the 16th largest economy in the world (Indonesia) Potential ongoing annual expense Although Congress initially authorized $700 billion for TARP in October 2008, that authority was reduced to $475 billion by the Dodd-Frank Act. Look- Through Expenses are an ongoing annual expense; data calculated as of Source: Page 32

33 Truth in Marketing Passive Fund Realities: Overall Expenses are Not Low Market Weighting Reduces Diversification Liquidity Risks remember the ETF crash on August 24, 2015 A Crowded Trade Page 33

34 Failed Engagement with Companies Index Fund and ETF sponsors are aware of their terrible voting results on executive compensation Their explanation that they engage with portfolio companies has not changed the voting and approval practices of the companies of which they are the largest shareholders. Page 34

35 The Current Index Investing System The top 4-6 shareholders in most S&P 500 companies are index funds. Index Funds vote in favor of management proposals 97% of the time. * Over time, executive compensation has ballooned, diluting shareholder value for all. ** 54% of the time buybacks are used to absorb the dilution caused by these expensive stock-based compensation packages. *** The active vote has value ERISA (the Employee Retirement Income Security Act of 1974) recognized the value of the right to say no. *Based on proxy voting in2016 **Economic Policy Institute, CEO Pay Rises as Typical Workers Are Less, Issue Brief #380, June Washington, DC. ***Data as of 2016, based on Wintergreen s analysis of dilution due to executive bonus plans and buybacks used to offset that dilution. Page 35

36 The Current Index Investing System Means Most Investors Lose The Role of the CFA is being Diminished Fundamental Analysis is becoming irrelevant. Valuations are being ignored. Corporate Governance is being ignored. Securities Analysts will probably have fewer jobs. Risk to price discovery as there will be fewer analysts to study new information to determine the price at which buying and selling is balanced. Page 36

37 Potential Solutions Starting a Discussion on how to Remedy these Issues Page 37

38 Wintergreen s Suggested Solutions to these Hidden Costs Clearer disclosure to improve voting decisions including: Greater transparency and disclosure of Look-Through Expenses: Portfolio companies should disclose the costs of dilutive stock executive compensation plans and the stock buybacks involved. This cost disclosure should be clearly identified in the annual report and proxy statement for each company. This standardized expense number, once properly disclosed, can be used by investors to make investment decisions as to which companies to avoid, based on their total LTE. Page 38

39 Wintergreen s Suggested Solutions to these Hidden Costs Clearer disclosure to improve voting decisions: Funds should disclose their true expense to shareholders based on the average LTE in their portfolios. If investors knew that the LTE for a fund was 4.3%, their investment decision may change. Page 39

40 Wintergreen s Suggested Solutions to these Hidden Costs Funds should refine their marketing to reflect the market weighting and to disclose the Look Through Expenses. Funds need to vote their proxies from the perspective of the investor and not the CEO. Wintergreen's research shows that 97% of the time, Index Funds vote in favor of executive compensation plans. Since the top 4-6 shareholders in most S&P 500 companies are index funds, the weight of their votes have a material impact on voting results. As we have learned from our activist campaigns, companies know this and count on these votes when creating compensation plans. The Result: Extreme Look Through Expenses Page 40

41 Wintergreen s Suggested Solutions to these Hidden Costs Change executive compensation plans from stock grants to cash compensation with long-term stock ownership requirements. Requiring management purchase shares with cash that they have paid tax on, and requiring minimum ownership provisions, will align managements interests with shareholder interests. The resulting savings can be used to benefit shareholders by increased reinvestment in the underlying businesses or by paying dividends to shareholders. Page 41

42 Discussion Q&A Page 42

43 THIS DOCUMENT INCLUDES INFORMATION BASED ON DATA FOUND IN FILINGS WITH THE SECURITIES AND EXCHANGE COMMISSION, INDEPENDENT INDUSTRY PUBLICATIONS AND OTHER SOURCES. ALTHOUGH WE BELIEVE THAT THE DATA ARE RELIABLE, WE HAVE NOT SOUGHT, NOR HAVE WE RECEIVED, PERMISSION FROM ANY THIRD-PARTY TO INCLUDE THEIR INFORMATION IN THIS PAPER. MANY OF THE STATEMENTS IN THIS PAPER REFLECT OUR SUBJECTIVE BELIEF. THE INFORMATION CONTAINED HEREIN IS NOT AND SHOULD NOT BE CONSTRUED AS INVESTMENT ADVICE, AND DOES NOT PURPORT TO BE AND DOES NOT EXPRESS ANY OPINION AS TO THE PRICE AT WHICH THE SECURITIES OF ANY COMPANY MAY TRADE AT ANY TIME. THE INFORMATION AND OPINIONS PROVIDED HEREIN SHOULD NOT BE TAKEN AS SPECIFIC ADVICE ON THE MERITS OF ANY INVESTMENT DECISION. INVESTORS SHOULD MAKE THEIR OWN DECISIONS REGARDING A COMPANY AND ITS PROSPECTS BASED ON SUCH INVESTORS OWN REVIEW OF PUBLICLY AVAILABLE INFORMATION AND SHOULD NOT RELY ON THE INFORMATION CONTAINED HEREIN. NEITHER WINTERGREEN ADVISERS, LLC NOR ANY OF ITS AFFILIATES ACCEPTS ANY LIABILITY WHATSOEVER FOR ANY DIRECT OR CONSEQUENTIAL LOSS HOWSOEVER ARISING, DIRECTLY OR INDIRECTLY, FROM ANY USE OF THE INFORMATION CONTAINED HEREIN. Page 43

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