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Active versus passive when prices are extremely stretched

Active versus passive when prices are extremely stretched

There’s a pithy marketing one-liner that has almost single-handedly produced a multi-billion dollar index-fund and ETF industry. It goes something like this; ‘Most active fund managers underperform the index.’

We can explore whether that is actually true in a moment, but I would like to offer an alternative one-liner; ‘The ASX/S&P200 has gone nowhere in a decade; why invest in the index?’ or another perhaps less pithy one-liner; “so much money has poured blindly into index funds that the underlying stocks are now mispriced, and cautious active investors – those with an eye to quality and value – will better protect investors funds.”

As passive index investing becomes ever more popular, the arguments that justify the switch from ‘active’ to ‘passive’ management weaken and then completely break down.

Most dangerously, as index investing grows in popularity so too does the divergence between stock prices and fundamental values. Retail investors are none the wiser, and simply trust those recommending the lazy and cheaper index-fund approach.

Strong market performance is having a positive impact on index investing’s popularity. The adoption rate can reasonably be expected to be highest when the market is at a crest and lowest when the market is on its knees – precisely the opposite of a successful investment strategy.

The promise of diversification, low cost and access to overseas markets are the top three reasons for the popularity of index funds and ETFs – but index investing, when it is directed to cap-weighted equity indices, is simply ‘dumb’ investing. In fact, this point was made by Warren Buffett when he recommended index investing to the masses; he made the point that it suits the “know-nothing investor,” — that is, the investor who has no interest in understanding a business or valuing it.

There are several reasons to be cautious on index investing, irrespective of whether that is through an unlisted fund structure or through an exchange-traded fund. You’ll notice that the S&P/ASX200 index today is lower than a decade ago. There is a very good reason for this; most of the index is weighted to large, mature companies that pay most of their earnings out as a dividend, leaving very little for growth.

High pay-out ratios mean investors get a yield but not much else. This is a serious problem if you want to maintain your purchasing power, as being able to afford rising utility, healthcare and entertainment expenses, requires growth in both your wealth and income.

By way of example, Telstra’s share price today, and its dividend in 2018, is barely higher than almost two decades earlier in 1999, but I bet your cost of living is more today, than in 1999.

As Ben Graham once wisely observed, in the short-run the market is a voting machine, but in the long-run it is a weighing machine. If the underlying companies cannot grow their earnings because of high pay-out ratios, neither can the index based on them. So the weak performance of the ASX/S&P200 index will lock investors into mediocrity.

Returning to the question of active managers underperforming the index, it is very true that the US index, as measured by the S&P500, has performed very well. It is also true however that 30 per cent of its gain this year can be attributed to funds flowing into just five companies; Amazon, Google, Microsoft, Apple and Facebook. Additionally, much of the funds flowing into these five companies have been via exchange-traded funds, the biggest of which is Morningstar’s SPDR S&P500 ETF whose top 10 holdings includes all the above-mentioned stocks.

A lot of investors’ futures are being held up by the profit outlooks for these five companies. Active managers are measured on a variety of factors including volatility, for which one measure is the Sharpe Ratio. If a fund delivers a 10 per cent return with 10 per cent volatility, the Sharpe Ratio is said to be 1. A Sharpe Ratio above 1 is exceptional. Since 1928 the S&P500 index Sharpe Ratio has been 0.4, but for calendar 2017, year to date, the Sharpe Ratio is on track to be 3.5. If index investors think this is normal, watch out.

Of course, as I write this, everything looks benign and nobody can see any risks, which is precisely why no risks are being priced in. When the market is rising, index investing looks sensible, but what happens when the index declines and investors want their money out and their ETF’s have bets concentrated in a narrow band of tech stocks?

While exchange-traded and index funds have been heralded as one of the most important financial innovations during the last decade, promoters fail to warn investors of their limitations and risks. Active fund managers, especially those who put the protection of capital above the last few percentage points of gain, are currently losing to the optimists and the index. Active managers, however, are focused on quality and value, and protecting capital, something that always wins in the long run.


Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.

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  1. I believe the ASX S&P 200 index that “has gone nowhere in a decade” is a simple price index that does not take dividends paid into account. Surely in a market like ours that both pays relatively high dividends and has an imputation credit system it is only fair to use the far better performing accumulation index.

    • Yes Graeme, if you had reinvested your dividends into that index there’d be a compounding effect but when reinvested into an index that has gone nowhere, the compounding can only be equal to the growth of the dividends over that time and remember a relatively small proportion of the total is being reinvested.

  2. Problem lies in diversification, e.g. how many fundies should the ‘know something investor’ invest in? Any basket of, say five fundies, might well underperform the ASX Accum index, ala Buffett’s ‘million dollar hedge fund vs index bet’. Also, a ‘know something investor’ might well outperform fundies after their asset and performance fees.

    • Plenty of Aussie funds have significantly outperformed the market over a variety of time periods. Probably far fewer over EVERY time period, but that’s probably not meaningful.

  3. Correct me if I’m wrong, but didn’t Warren Buffett advise most people are better off just buying the S&P500 index….

  4. I wonder if some of these ETF’s and index funds will be on sale at below net asset value when the dumb money is running for the exits, all that blind buying might turn into panic selling when the minsky moment finally arrives.

  5. Roger,

    I think is time to correct this hoary old chestnut…. “As Ben Graham once wisely observed, in the short-run the market is a voting machine, but in the long-run it is a weighing machine.”

    The truth of the matter is that this is a misrepresentation of what Graham had to say. Responsible for that misrepresentation was none other than Warren Buffet in his 1993 Letter.

    The history of the matter and Graham’s actual statement on the matter are as follows:

    “In the short-run, the market is a voting machine – reflecting a voter-registration test that requires only money, not intelligence or emotional stability – but in the long-run, the market is a weighing machine.”
    – Attributed to Benjamin Graham by Warren Buffett in a 1993 Berkshire Hathaway letter

    The actual quote, from Graham’s 1934 book Security Analysis, is:
    “In other words, the market is not a weighing machine, in which the value of each issue is registered by an exact and impersonal mechanism, in accordance with its specific qualities. Rather we should say that the market is a voting machine, whereon countless individuals register choices, which are partly the product of reason and partly the product of emotion…. Hence the prices of common stocks are not carefully thought out computations, but the resultant of a welter of human reactions. The stock market is a voting machine rather than a weighing machine. It responds to factual data not directly, but only as they affect the decisions of buyers and sellers.”

    Graham’s statement and his conclusion is far more nuanced that that misrepresented by Buffet. … ” The stock market is a voting machine rather than a weighing machine. It responds to factual data not directly, but only as they affect the decisions of buyers and sellers”


  6. Eric Ogard from Monea Investments also has an article about the high Sharpe ratio and an even more interesting chart showing :
    (i) the current positive Sharpe streak is the longest since 1928
    (ii) the Sharpe ratio has never exceeded 3 until this year
    ref: http://www.managedfuturesinvesting.com/managed-futures/news/aisource-news/2017/06/14/the-s-p-500-index-in-2017

    I appreciate that index funds can carry significant risk & can never outperform the index they are following. However, their rise is simply a reflection of the observation that ‘Most active fund managers underperform the index’ i.e. stock picking is very difficult and it is simply not a numbers game – you have to know the business and its future prospects – which even fund managers have a difficult time doing. Furthermore, very few active investors have surpassed the index over the long term (> 10 years).

    Whilst the Montgomery funds haven’t been around for that long, their performance (esp the Montogmery fund) is in the top 25% of all funds which is a testament to the team’s ability to pick stocks for the fund.

    If it is possible for the alpha plus fund to short an index then perhaps the S&P500 is one that should be one the list.

  7. Hi Roger

    Fully agree with you that active investing is the preferred way to go, but Index investing also has it’s place if timed correctly.

    Whilst it’s true that the ASX S & P 200 has not surpassed the peak it reached in October 2007 that only is a problem for Investors who did not realize the market was in a bubble at the time and did not sell out. For those that did the returns were excellent. Of course things will look bad if you compare the peak before the crash to now. That’s cherry picking.

    Check these stats out and you will see what I mean.

    ASX S & P 200 INDEX

    – 7.3/2003 2744
    – 12/10/2007 6749 ( 7/3/2003 – 12/10/2007 – 146% Increase over 4 yrs 7 mths)
    – 6/3/2009 3145
    – 3/11/2017 5960 (6/3/2009 – 3/11/2007 – 90 % Increase – CAGR approx. 7.5%)

    Clearly the market was in bubble territory and overvalued leading into 2007 – poor souls who failed to see that. If you invested in the Index around it’s low point in 2009 your returns would amount to 7.5% capital growth plus about 4% in dividends plus the bonus of franking credits of least an extra 1% – all up about 12.5% pa. Not bad!

    Some say time in the market is important – I say timing the market is everything.
    Any Investor who ignores stretched valuations and bubbles is doomed. There comes a time when selling out is the only option. The problem is that few are disciplined to do it.

    Are we currently in bubble territory? Are valuations currently stretched?

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