Stairway to heaven or highway to hell? – 3rd quarter, 2016
I read an article in The Economist a few weeks ago about a concept called the Nash equilibrium, named after John Nash who won the Nobel Prize in Economic Sciences for his contribution to game theory. The article highlighted that the Nash equilibrium helped economists better understand how self-improving individuals could lead to self-harming crowds.
The first thing I thought of was the massive rise in “low-volatility” funds and ETF products. If the Nash Equilibrium was applied to these trends it would likely explain that as more and more investors rush into them, the more the promise of low volatility and peace of mind is a fairy tale.
The second thing I thought of was how index funds will eventually find themselves out of synch with the value of their underlying holdings all due to self-improving investors who appear to be acting in their best interest. That is, investing in the lowest fee products possible while often outperforming the majority of investors – otherwise known as an index fund. Why wouldn’t all self-improving investors use this as their solution to build their wealth?
This commentary will help explain why we believe index investing will work (until it doesn’t) and why it will stop working. To explain, here’s a quick story.
It’s all about insight
Let’s go back to the 1980s when index investing was an insignificant part of the market. Every time you bought or sold shares there was another investor on the other side of the transaction with an opinion on that same stock. Your ability to outperform was based on having insight about that stock that the other person didn’t. This was capitalism at its finest – two well-informed investors determining the price of each security.
Luckily for you, there were investors who weren’t always as well informed as you. Or if they were, their information was different:
Some would have good insight into the next quarter, but not the next three years
Others were technical investors which meant they waited for a couple of squiggly lines to intersect before buying. As time passed you realized that not many of these guys became rich so assumed they were exploited by you and others like you
Some were momentum investors who tried to chase performance by buying when stocks were on the rise and selling on the decline. They always gave you a chance to sell your stocks for a higher price than you thought possible and buy at prices so low it seemed unfair
There were those who bought stocks based on a tip from a friend or co-worker without really knowing much about the business. More often than not they’d become donors to your financial health
Closet indexers started trending during the 90s. Buying stocks from them was kind of like stepping into a ring with a one-legged kick boxer. They’d try their best but there were unmistakable constraints imposed on them that prevented them from succeeding
Everyone described above was trying, but their approaches often caused a dislocation between the stock price and the value of the business. The last 30 years were hard but there were a lot of opportunities to exploit those investors who treated a stock as a piece of paper and not a business. Even if that only happened with 3% to 5% of the universe, it was all you needed to outperform the market.
A friendly animal with no teeth emerges
Over the last 10 years you noticed a new class of investor in the marketplace – the passive index investor. They didn’t care what stock they owned, as long as it was in the index. They were an odd bunch. It was all about exposure to the market for a low fee. They wanted to own every stock in the index which included the good, the bad and the not so pretty ones. That was the only criteria for purchase!
At first glimpse, it looked like passive investors were putting their faith in no one. They believed the markets were efficient. That there were enough smart people trying to determine the right price for investments that there were few, if any, mispriced securities. You realized passive investors put their faith in people like you, those who still tried! This allowed them to buy and sell their stocks at fair value without lifting a finger for analysis, trusting in the homework of others. Not necessarily the qualities we want to teach our kids, but for those who chose to follow the path to effortless mediocrity it’s been a free lunch for a few decades.
The group with no questions
The inescapable reality of index investing is that these investors have decided there’s no point trying. That’s why it’s called “passive” investing. Passive investors no longer believe in the importance of asking questions about the businesses they own. Questions like:
Is it a good company?
Is it facing steady decline?
Is the accounting clean?
Are the earnings overstated?
Is management competent?
Am I buying it at a dumb price?
None of these questions mattered anymore!
Initially this group flew under the radar, but lately more and more of your transactions are with people who decided it isn’t worth trying! You notice the dislocation between price and value has become a more common occurrence, likely because you’re trading with people who are ignorant to price and value.
Many of your friends become index investors. It’s tempting to follow the herd into this passive investing utopia with low fees and market returns with zero effort. You recognize it would diminish your soul to simply aim for average, so you drive on.
You realize that investors buy into the fallacy of the dumb money experiment because they take comfort in assuming that since they own the market, they’ll earn the same return as the market.
Since passive investors don’t ask questions and put their faith in other people to do their work for them, they don’t even bother to think about what the world would look like if passive investors dominated the investing universe. For example, what will become of market returns if this indexing trend continues and dumb money represents over half the market?
Blind leading the blind
Let’s fast forward to a world where everyone but you has become an index investor. The calamity that ensues would obviously occur well before only one active manager remains but sometimes it takes going to an extreme to prove a point.
If there are no other active managers and the passive investors buy and hold, you’d have no trading partners. Passive investors would earn the market return because they aren’t trading. The market return would be determined by no one as there isn’t anybody reliable to set the price. There’s an old idiom about the blind leading the blind that comes to mind in this example.
Awash in dumb money
Luckily, this isn’t how things would pan out for you. Passive investors are rarely ever truly passive so they’d still trade because they won’t be able to escape feelings of fear and greed. And they’d probably reinvest their dividends, continue to save each year for retirement and put that savings into the market. Others would need money and have to sell their stocks. There would also be changes to the composition of the index which would force them to trade. Really only those who hold the index and never trade are truly passive. Each time a passive investor trades is an opportunity that can be exploited.
Let’s assume you know one stock really well. It’s called ABC Company, held in the index and you’ve determined the fair value is $20 per share.
When “investors” decide to add to their retirement savings through their low-fee index fund, they blindly buy each representative holding in the index. Who determines the price if everyone but you is a passive investor? You’d be the price setter of ABC, but the prices of the remaining stocks in the index will be a crapshoot.
Initially you find it hard to believe that otherwise sophisticated people could be so careless with their money. They don’t ask about the value of a business so you get to determine the buy and sell price. Being the savvy active investor that you are, you’re going to set a price well above $20 when there is more demand of ABC Company than supply. When there are more passive index sellers of ABC, you can set your buy price all the way down to $1 if you’d like. The passive indexers have relied on you, and people like you, for decades to set the fair price. They trust you implicitly! After all, it’s all about getting the proper “exposure” so they can get their “market return” even if it’s not good value.
Though they don’t think for themselves, they still have feelings and will feel the volatility. The proprietors of the index funds would make excuses for the volatility that would sound perfectly logical for most of the non-thinkers.
The profitable facilitator
The herd would look to you to set the price. You’re legally allowed to exploit them. The index manager’s job is to match the composition of the index for a promised low fee. You’d be the happy facilitator.
Given the example above, the notion that increased index investing shrinks the opportunities for active managers is absurd.
The fun part of exploitation
If you became well-educated in other names in the index, you’d be able to take advantage of passive investors more often. When they trade, you’d profit solely at their expense. You’d decide how much of their money to take on each trade. The growth of your wealth will be directly proportional to the volume of their trades. If they trade enough, they’d eventually have no money and you’d own the entire market capitalization of the stock market. At that point, would the returns of index funds match the return of the market?
This is what would happen if you were the last active manager. It probably wouldn’t get to that point though because as soon as passive investors started to get heavily exploited, some would start thinking for themselves. They’d cut and run well before this utopian exploitation point.
More dumb money = more opportunity
The example above assumed you were the only active manager. Even if there were two active managers left would you spend your time trying to profit at the expense of the other one? Of course not, you’d both exploit the dumb money. Same scenario if there were three or four active managers in a sea of indexers. With passive index funds purportedly representing 40% of some markets,i, the supply of dumb money is beginning to reach critical levels for exploitation.
This brings us back to how self-improving individuals can cause self-harming crowds. Each passive investor thinks they’re doing what’s best for them – investing in a product with low fees while effortlessly achieving market returns. It works if only a minority uses this strategy because they can rely on the majority for proper price discovery. With fewer and fewer active managers determining fair prices, passive investors would increasingly be left having to buy and sell at something other than a fair price. The very people they relied upon when they were a minority would exploit them when they become a majority.
This commentary is intended for our investment partners. We’d appreciate if you’d refrain from forwarding it, as we’d like the momentum behind the dumb money movement to continue.
iTom Anderson, “Investors say ‘forget it’ to active funds. Outflows from actively managed funds hit record pace,” CNBC, August 29, 2016, http://www.cnbc.com/2016/08/29/investors-say-forget-it-to-active-funds.html.
Be wary of the Timothy Dalton of Bonds
By Frank Mullen, portfolio manager
Historically, high-yield bonds have been an attractive asset class. As their name implies they’ve generally provided investors with a relatively high yield in exchange for the possibility that some of these borrowers would default and not return 100% of their principal.
This is an important concept for investors to consider when investing in higher yielding (and therefore lower credit quality) companies. It’s not enough to say that a company’s bonds are yielding 10% and are much more attractive than the paltry yields being offered by government securities. That logic only looks at return and fails to analyze the most important aspect of any investment – the inherent risk with investing capital.
There’s only one reason that corporate bonds are yielding such a high level – the market judges them to be a high credit risk. If you pay $100 for a bond and two years later they default and only pay you a fraction of that amount, you’ve suffered from permanent loss of capital. That juicy 10% yield didn’t compensate you for their default risk.
The EdgePoint investment approach endeavours to find bonds where our opinion differs from the market. Can we find a bond that yields 10%, where we have a thesis on why it will increase its levels of free cash and pay down its debt? Does it have a valuable asset that we think can be sold to ensure that our principal is paid back? This is the value of true active credit management and we’re firm believers that it’s the appropriate way to invest in credit.
Passive investing has become a very popular way to invest in high-yield bonds. Passive investors believe that by buying an index they’ll earn a yield that’s more than enough to cover the loss from eventual defaults. That’s been the case in the past, but history isn’t always the best guide. We’re experiencing unprecedented events in global financial markets and that may have real effects on future returns. I realize that saying “this time is different” is generally a red flag but consider that investors passively buying an index are receiving a low yield relative to history at a time when risks are increasing. The average yield on the high-yield index since 1986 has been 10.5% and is only 6.6% today.i
These low yields are coming at a time of increasing default risk. Defaults have increased to 5.3%, the highest level since the financial crisis.ii One of the most important changes during this cycle is the declining recovery level. When a borrower defaults, bond holders usually get back a percentage of their principal (the recovery rate). Recovery rates have historically been around 40%,iii but today are averaging only 24%.iv You’d need a lot of coupon payments to make up for a principal loss of that size.
I’m not completely against passive investing, but I do wonder if the average investor in a high-yield exchange-traded fund (ETF) understands this math. The index currently yields 6.6%, defaults are at 5.3% and recovery rates are 24%. If these numbers stay static, a passive investor in the index can expect to yield 2.57%.v Can that even be called high yield?
A good credit analyst should help you beat the index. It’s our job to disregard the average businesses in the index and focus on ones that we can understand and have an opinion on. Thorough credit analysis doesn’t guarantee success. We’ll make mistakes but it should help us avoid buying companies that default at the same rate as an index because the index doesn’t even try to discern a company’s credit quality.
The popularity of passive investing in high-yield bonds has helped true active managers because investor behaviour affects the prices of many bonds. When investors are fearful, as they were at the beginning of 2016, high-yield ETFs get redeemed and the bonds sold regardless of whether or not the fundamentals of the underlying business have changed.
Active managers can capitalize on this indiscriminate selling by buying bonds from sellers who don’t know anything about the credit that they’re selling. It’s not uncommon to see bond prices jump up or down based on ETF flows. Shrewd credit managers know that buying bonds the day after ETFs have experienced declines can be a great opportunity.
We welcome the volatility that’s being created by these passive investors and are confident that we’ll continue to find opportunities. We endeavour to beat the index through thorough credit analysis and are confident that we can continue to find investment ideas in unloved credits. There have been several volatile periods this year that allowed us to buy bonds at very attractive rates and we’re pleased with the returns we generated. Unfortunately, that volatility didn’t last long and the investor fear experienced earlier this year reverted back to an almost universal reach for yield. Should today’s complacency return to fear, we’re ready to implement our investment approach and try to capitalize on the opportunities present in the market.
ii Credit Suisse
iiiMoran, Nada, “What determines creditor recovery rates?”. Kansas City Federal Reserve.
iv Credit Suisse
v Expected Yield = Current Rate - Default Rate x (1 - Recovery Rate), or 0.66 - 0.53 x (1 - 0.24).