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Passive vs. active investment management?  There’s been a debate over which methodology is better for long term investment success and recently, passive has been winning.  If you look at inflows/outflow to passive and active managers, you can see this trend clearly.

Here’s another chart  by Credit Suisse which shows the great divide between active and passive US stocks:

 

In last month’s financial markets update, I included a video and slide deck to one of  the most interesting presentations on the distortions the ETF industry is having on the markets.  According to Steven Bregman, he believes this is the biggest bubble he’s seen in his career and it’s hard to argue with him.  I see distortions all of the time in the individual municipal bond market relative to the municipal bond ETF market.  For instance, there are days when the bonds my client own in their accounts go down, while similar ETF’s are up in price that day.  How does that occur when the bonds I own are owned inside of the ETF that is going up?  I follow the CFTC futures positioning on a variety of asset classes since herding becomes glaringly obvious when traders are all betting in one direction.  In the financial markets, there’s been massive herding in ETF’s that invest in all asset classes (stocks, bonds, commodities, etc.) which is seriously distorting prices.

When someone buys an index fund, there’s a fundamental lack of price discovery.  What I mean by that is no one knows what they’re buying.  If you bought the S&P 500 index, how much did you pay for Apple, Microsoft, McDonald’s, etc?  You don’t know and I imagine you don’t care.  This has distorted things in such a way that it will cause problems and opportunities when the pendulum swings the other way.  Indices are market cap weighted which means the biggest companies have the biggest weightings in the index.  And if the companies keep attracting capital because people are investing in index funds, the largest stocks keep going higher and then continue to increase in weighting within the index, creating a bubble of sorts.  Passive ETF’s and market-cap weighted ETF’s have caused an artificial supply and demand.  And due to the prominence of index investing via Roboadvisors such as Wealthfront and Betterment, there’s a daily automatic bid for these indices, regardless of price and fundamentals.

Below are the top 25 stocks in the S&P 500 ETF (SPY) according to Morningstar.  These stocks represent almost 34% of the index, even though the index has 500 stocks.  5% of the index (25 stocks) equates to 34% of the total which isn’t as diversified as it seems.  Look at the column to the far right which show price to earnings ratios (P/E ratios).  A simple average of the top 25 stocks in the S&P P/E ratios is almost 33!  But no one seems to know or care what they’re buying!!

 

Market cap weighting also applies to bond indices, but in a different way since the most indebted companies have the largest weightings in the index.  Take for instance the iShares Emerging Markets High Yield Bond ETF whose 2nd largest position is in Petrobras bonds.  Petrobras is the most indebted company in the world and has been plagued by scandals and corruption which have been widely publicized.  I understand (but don’t agree) that the largest companies have the highest weighting, but being the most indebted company isn’t a good thing.  But again, people don’t know what they’re buying.  The iShares ETF itself only has a yield of 6.3% (as of the date referenced below the image) while the US high yield ETF has a yield of 5.6%.  Are you really being compensated for the extra .70% of return for the risk involved by owning Russian Federation and Lebanese bonds?

Take a look at the Russian Federation 14 year bonds and the Lebanese bonds in the fund.  The country of Lebanon has a lower yield than Wendy’s even though the last time they published GDP was in 2008.  The 14 year Russian Federation bonds have a lower yield than IBM’s 10 year bonds!!  How is this possible?  Do you really believe that Russia is more likely to repay their bondholders than IBM??  Do you believe that you can sell these bonds individually at these prices?  Again, I’ll keep going back to the fact that there’s little price discovery occurring in the markets and index fund investing has a lot to do with it.

 

Because of the passive investment wave, correlations have also been rising causing a correlation convergence.  The individual stocks within the S&P 500 as well as foreign stock markets now are highly correlated with the S&P 500.  We saw this happen during the financial crisis when it was easy to push a sell button for an ETF and caused prices to drop further.  Since then, ETF’s have grown incredibly in size which could further exacerbate a sell-off.

 

Back to price discovery one last time.  Coca Cola was trading at a P/E ratio of over 30 in the early 70’s, but they had double digit earnings growth.  Today, Coca Cola trades around 22 P/E even though earnings and revenues have been slightly negative for the past 4 years.  McDonalds revenue is up 8% total from 2008 to 2015 while their debt climbed $14 Billion (+136%!).  Net income is flat and equity is down almost 50%.  But the stock is up 90%!!

Does this make sense to you?

Please understand this isn’t a post blasting index investing because it absolutely has it’s place in portfolios.  The problem is the pendulum has swung too far in one direction and is now causing distortions.

Jack Bogle, the godfather of index investing, was recently quoted saying “If everybody indexed, the only word you could use is chaos, catastrophe…There would be no trading, there would be no way to convert a stream of income into a pile of capital or a pile of capital into a stream of income. The markets would fail.”  You can read that article here.

 

If you’re interested in starting a dialogue and learning how we can help, please click the link below to book a call or meeting with us.

 

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Best Regards,

Jared Toren
CEO & Founder

Steven Bregman’s Presentation and Original Slides

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Author: Jared Toren

Jared Toren is CEO and Founder at Proper Wealth Management. Proper was born out of frustration with the inherent conflicts of interest at big brokerage firms influencing advisors to sell products that were not suitable for clients but profitable to the firm along with a consistently mixed message of who’s interest was supposed to be put first; the clients’, the firms’, shareholders or advisors.

At Proper, our clients interests come first. We are compensated the same regardless of which investments we utilize so there’s no incentive for us to sell high commission products. Since we focus on a small number of clients, we are able to truly tailor our advice to each person’s unique circumstances.

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