In the short run, the market is a voting machine but in the long run, it is a weighing machine.
The S&P 500 gained 7.8% through September 30, driven by a recovery in Energy and ETF flows into Utilities, Telecom and Consumer Staples. OPEC’s September 28th announcement of a production freeze gave the Energy sector an additional boost at quarter-end. Small cap stocks returned 11.5%, outperforming the S&P 500. High yield corporate bonds, which we view as a less risky alternative to small cap, returned 12.7%. While high yield bonds remain relatively attractive, yields have declined to 6.2% with the strong performance. European and Japanese stocks continued to languish, with concerns over stagnant economic growth and the impact of negative interest rates weighing on market participants. Emerging Markets continued to be the best performing major segment of the equity markets.
The Federal Reserve voted 7:3 to leave the Fed Funds rate unchanged at 0.50%. Futures markets and Fed watchers expect no change this year and a 50% chance of a quarter-point increase in the first quarter of 2017. Inflation expectations remain muted with the Ten-Year Treasury Inflation Breakeven Rate – the inflation rate at which the returns of nominal ten-year Treasury bonds match returns of the Treasury Inflation Protected Securities (TIPS) – hovering around 1.6%. This number is below the current core CPI of 2.3% (core CPI is defined as inflation less the volatile food and energy components). If food and energy prices fluctuate around current levels, total inflation will converge toward this core rate, providing a small return advantage to TIPS. TIPS, of course, also offer protection against the risk of future higher rates of inflation. The prospect of a tightening Fed combined with a low inflation breakeven rate makes TIPS an attractive alternative to traditional Treasury bonds.
While the quality of discourse in the US Presidential election continues to reach new lows, the potential impact on the economy and financial markets is limited. Clinton remains a strong favorite, both in polls and in the betting markets. Furthermore, whoever is President next January will likely have to contend with a split congress that will negate either candidate’s ability to implement aggressive policy changes. Historically, presidential elections show little or no impact on the stock market. S&P 500 returns in past election years show about the same range of positive and negative returns as any given year in the stock markets. If one had only invested in presidential election years from 1948-2012 the return would have averaged 6.3% compared to 7.2% over the entire 1948-2012 period. These numbers are skewed by the 2008 Financial Crisis and the corresponding -38.5% return for the S&P 500 in 2008. Looking at presidential election years from 1948-2004 reveals a slight outperformance over the S&P 500 over the whole period. Another thought experiment would be to go back to the beginning of any election year and ask: ‘Had I known the outcome, would there have been easy money to make picking stocks or timing the market?’ Aside from perhaps some modest sector volatility, such as buying defense stocks if the Republican candidate wins, it is difficult to make a case for this foreknowledge being particularly valuable.
78% of active managers underperformed in 2015, and 2016 looks to be on track for similar results. Have active managers become that bad, or is some other factor at work? The conventional argument for passive management rested on the observation that the equity market was dominated by traditional stock pickers; therefore the index must represent the average active manager return before fees. As the market return is the average of active managers, the expected underperformance of active strategies derives from active management’s higher fees and trading costs. Confident that financial assets were fairly priced, an index fund investor could then free-ride on the work done by active managers. The index fund investor could buy and sell at a fair price because that price was set through competition among active managers incorporating all available public information into their process.
Passive investment mirrors the aggregate views of active managers. When a segment of the stock market becomes dominated by speculative activity it becomes reflected in passive strategies. For example, the 21.0% return of the S&P 500 in 1999 was entirely driven by the 78.7% return of technology stocks. Similarly, during 2006, the 19.2% return of financial stocks drove the 15.8% return of the S&P 500 before the 2008 Financial Crisis subsequently destroyed most of the value in the sector.
The index performance during these periods mostly reflected the participation of active managers in these speculative booms. During the Tech Bubble, growth managers tilted their portfolios toward technology stocks and numerous specialty technology funds were launched. ETFs also played a role – particularly QQQ, which tracks the NASDAQ 100 Index. However, ETFs were much smaller players than today. QQQ peaked during the early 2000s at approximately $26 billion in assets which comprised a tiny fraction of the $4 trillion peak market cap of the Technology sector. Sector ETFs today represent as much as 7% of the market capitalization of the sectors in which they invest. Additionally, specialty equity ETFs that focus on stocks with particular attributes, such as high dividend yields or less volatile stocks, have large portions of their portfolios in sectors that contain stocks meeting their criteria. For example, dividend-focused ETFs tend to be heavily weighted in the Utilities sector.
These specialty equity ETFs, often referred to as ‘Smart Beta’ in marketing jargon, represent a major new player in the active vs. passive investment dynamic. These strategies buy stocks based on simple quantitative factors without regard for deeper fundamental analysis. The ETFs follow a variety of strategies including value, momentum, low volatility, low beta, or high dividend yield. The marketing of these products relies heavily on backtested results due to the short time periods of actual live investment history. Backtest results reflect a market environment where these strategies largely did not exist. A fundamental uncertainty therefore surrounds the behavior of these strategies once they become widely adopted in the financial markets. Most of the investment algorithms place no consideration on valuation metrics. They buy stocks that rank high in desired factors regardless of valuation. Not surprisingly, flows into ‘Smart Beta’ ETFs have boosted prices of stocks meeting desired factor characteristics. This phenomenon is most apparent in historically stable, but currently expensive and slow growing sectors such as Utilities, Real Estate and Consumer Staples. Research conducted by Research Affiliates revealed that stocks with high profitability and low past volatility currently trade at record valuations relative to the rest of the equity market. A benign feedback loop begins with investors buying a ‘smart beta’ ETF on the basis of attractive backtested results. This pushes up the prices of the stocks in the fund, in turn attracting new investors believing the live results ‘prove’ the strategy works. This cycle can quickly become vicious as future returns from overvalued stocks disappoint, prompting fund redemptions which place additional selling pressure on these stocks.
Buying stocks solely on specific attributes such as low past volatility or high levels of profitability without regard for growth and valuation is not a sound investment strategy. Investors should understand what they own and why they own it. The silver lining here is that these specialty ETFs are setting up active strategies to outperform at some point in the future. The stocks most favored by these ETFs are lightly owned by the active managers we follow. The churn of the ETF strategy du jour does create opportunities for diligent investors. Currently the opportunity consists of simply not owning overvalued stocks. At some point in the future, ETF flows will reverse, valuations will swing the other way and a buying opportunity will arise. While this reversal will likely not be as dramatic as the Tech bubble or the meltdown of the Financial sector in 2008, it will be meaningful in the current low return environment.
– Stephen C. Browne, CFA
Chief Investment Officer
Chief Compliance Officer
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