Investors in index funds should be very cautious
In December 2014, I wrote an article for The Australian titled ‘Beware the lure of the ‘cheap’ index fund: it’s full of junk’. Today, I’d like to repeat that warning. Investors who think ETFs give them safety through diversification are no more protected than those who invested in mortgage backed collateralized debt obligations (CDOs) before the GFC.
At Montgomery, we have warned investors many times about the dangers of following, lemming-like, the vast hordes of mindless bandwagon jumpers into the ETF craze – a trend that others have likened to the go-go investing boom of the 60s, which ended rather badly.
One of our points has been that for Australian investors at least, the long-term track record of the index does not justify its popularity. Importantly, thanks to a structural weakness, which is itself a consequence of dividend franking, the index returns of the future are unlikely to diverge dramatically from those poor returns achieved to date.
To summarise, the large companies that dominate the Australian index are not only challenged structurally (supermarkets and Telstra) or cyclically (banks and iron ore miners) they are also paying the majority of their earnings out as a dividend. Australia’s franking system ensures dividends are far more valuable to investors than they are to companies. The corollary of a high dividend payout ratio however is a low level of retained earnings for growth. And if earnings don’t grow, neither will the share price longer term. Telstra is a classic example of this. Its earnings are scarcely higher than a decade ago and neither are its shares.
And our main point is simply that index investing is just dumb investing and by that I mean the investor buys without any reference to quality or value – two factors that we know have a big influence on long run returns.
In this post however I wanted to add to the list of dangers of index investing by reiterating the points made by others.
Late last year Horizon Kinetics’s co-founder, Steven Bregman, enunciated a damning report into the prospects for ETF investors, labelling indexation ‘the delivery agent of the great bubble’.
One of his points was made most clearly by the allegory of a time traveler from 2016 who went back three years and inadvertently left the subsequent three years’ financials of Exxon behind. That document would show the oil price down 50%, revenue down 46%, earnings per share down 74%, the dividend-payout ratio almost 3x earnings and total debt up 129%. What you would not know is the share price. Like Steven, I suspect you would short sell Exxon on the back of the information. The stock was up 4% from the second quarter of 2013 to the second quarter of 2016 and Bregman called it “an exercise in levitation’ thanks to the distortion of prices by index investing.
Index investing is causing distortions across all markets and Bregman examines the market for bonds where the conclusions about values are much harder to argue against than in equities.
At the time of his presentation in October last year, the US 10 Year benchmark yield was 1.7%. IBM’s AA- 10 year notes was at 2.5% and it seems reasonable 80 basis points is reasonable compensation for the extra credit risk lending to IBM. He also noted Wendy’s CCC+ at 6.9% was also reasonable and as check the iShares High Yield Corporate Bond ETF was yielding 5.6%.
As a sanity check, however, Bregman then asked what the market yield should be on the Russian Federation’s 7.3% BB+ bond with 14 years to maturity, reminding the audience that oil and gas revenues made up 50% of the country’s revenues and 10% of the public workforce was being sacked. He also asked what the Lebanese Republic’s 8 ¼, B-, 5 year note should be noting that the last time the country published its GDP number was in 2008 and Hezbollah, the state within the state is a participant in the war in Syria. After mentioning that the Russian bonds were trading at a yield of 2.3%, and less than IBM, and that Lebanon could borrow at a rate of 6.2% – lower than Wendy’s – he pointed out the Russian bonds were a 7% weighting in the iShares Emerging Markets High Yield Bond ETF and that the Lebanon notes were a 3.5% weight. He then observed that the iShares EFT had rallied 16% in the month of August!
Given the yields did not adequately compensate for the risk of investing in Russia and Lebanon, and that you could not sell these bonds individually at those market yields to any reasonable investor, Bregman concluded forces other than credit analysis were driving bond prices.
Indeed, the same forces are driving, nay distorting, asset prices globally and those forces are simply a tide of money flowing into ETFs without any research.
In the debt market ETF’s weightings are determined by the float or the amount of debt on issue. If a country issues more debt, its index weight rises and ETF’s have to own more of it. The allocation is not based on credit risk analysis. There is no analyst at the ETF provider or at the pension fund that invests in the ETF and the algorithm that determines the weightings does not contain and evaluative factors. Therefore there is no price discovery, there is not really a true market for these assets.
In an example debunking the supposed diversification benefits offered by ETFs Bregman noted: “The iShares REIT ETF, with a 2.8% yield—which I personally see as 35x earnings—has a beta of 0.72. That is low-risk by definition. But which beta should be used for that definition? The beta for the three years through August 2016? Why not the beta for the three years to March 2007?
“Because the beta at the end of March 2007 was even better—an incredibly low 0.3—only 30% of the volatility of the S&P 500. By February 2009, two years later, the ETF fell 90%, and even Simon Property Group shares fell almost 70%, while the S&P fell about 46%.
“All that beta can actually assert is that a stock declined by less than other equities during the measurement period. The Simon Property Group beta (5- year) today is 0.54. Ipso facto, as among the safest of securities, it is included in the most popular of the low-volatility ETFs, which is the iShares Minimum Volatility ETF (USMV).”
In conclusion Bregman argues that a massive bubble exists in the markets that is going unnoticed because this bubble does not have a massive spout or spike that everyone can see. This bubble, he contends, is more like a rising sea – the entire market is elevated.
The trillions of dollars flowing into ETFs are distorting all asset prices and those who have invested believing they are diversified are no more protected than the municipal funds that invested in mortgage backed collateralized debt obligations (CDOs) while believing geographic diversification would protect them from default.
This is ironic given after 2007 the popularity of ETFs was fuelled by participants desiring less sector risk, less company specific or idiosyncratic risk and less manager risk. Bregman notes, “devising subsets of the index accentuates a structural flaw of the market-cap weighting system: the top-heaviness problem. With time an index tends to get concentrated. Investors in the iShares U.S. Energy ETF presume to be buying a diversified portfolio. They fled idiosyncratic risk. Do they know that 50% of the fund is in just four companies, that they’ve actually fled right back to buying idiosyncratic risk?”
On Exxon Bregman notes; “Aside from being 25% of the iShares U.S. Energy ETF, 22% of the Vanguard Energy ETF, and so forth, Exxon is simultaneously a Dividend Growth stock and a Deep Value stock. It is in the USA Quality Factor ETF and in the Weak Dollar U.S. Equity ETF. Get this: It’s both a Momentum Tilt stock and a Low Volatility stock. It sounds like a vaudeville act.”
Blind basket-based ETF investing has disrupted the price discovery mechanism (which is why value investors cannot find anything to buy) and Bregman believes when the bubble bursts it will be the dawn of a “golden age” for active managers. In the meantime investors in index funds should be very cautious.
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.
Max Zan
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What is my definition of risk and return?
What is my definition of average Risk?
– Good questions Roger
In the context of all Investments I would define risk and return to mean the monetary return required for the level of risk associated with achieving that monetary return. In doing that the 10 year Australian Government risk free Bond rate is the Benchmark I would use.
In the context of Australian Sharemarket Investments I would define average risk and average return to be the average long term ( decades ) historical monetary return achieved for the risk associated of having invested funds in the ASX All Ordinaries Index. I also refer to that as average market risk and average market ruturn. It’s also a Benchmark and is taken to have or to actually be a Beta of 1.0
In my opinion high growth stocks generally tend to be more volatile ( Beta greater than 1.0) and therefore riskier than an investment in the ASX All Ordinaries Index . That Index has over decades produced an annual average return of approximately 9.6% on a PE of 15. That represents and earnings yield of 6.7% pa and growth of 2.9% pa . A growth rate that seems to be in line with GDP growth
High growth stocks have growth profiles that are significantly higher than 2.9%pa and if they are considered to have above average market volatility and risk associated with their growth profile , it’s then my view that above average market returns are justified and desirable. What those above average market returns should be is subjective and also very much stock specific – there are many factors that are taken into account when arriving at an appropriate discount rate to use in a DCF Valuation.
I welcome your Comments. – In the meantime, I’m heading off to the Pacific Ocean to catch the next rising tide to test if my rusty leaky tinny can overcome geo gravitational forces and achieve levitation.
Max Zan
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Roger – In reply to your comments I have the following to add
– Junk can beat Quality for longer than one year
– Quality stocks do not always win if you have paid too much for them initially
– Resource and cyclical stocks are worthy of consideration at certain times in the economic cycle
– Active managers who can beat their benchmark index will attract funds and those that don’t will lose funds.
– Investors have a very low tolerance for active managers who underperform their index benchmark for extended periods of time
– A rising tied does not always lift all boats. Different sectors of the market do not always rise and fall together
– Growth Investing tends to have higher than average risk so higher than average returns are expected
– Sitting on the sidelines and watching has it’s rewards when valuations are stretched
– Existing and potential Investors expect outperformance
Roger Montgomery
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Thank Max. We are in violent agreement on many of your points. Our cash balances are suggestive of a “sitting on the sideline” stance so we agree it has its rewards. I suspect however JFK would say there’s no rising tide if all boats aren’t being lifted! It was his aphorism you are modifying. By definition, then, if all boats are not being lifted it is not a ‘rising tide’. Whether we agree with you on “Growth Investing tends to have higher than average risk so higher than average returns are expected” would depend on your definition of risk and return as well as your definition of ‘average risk’ – whatever that is.
Max Zan
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Hi Roger
Thought that article of yours would put the cat amongst the pidgeons.
I agree with you that Index investing is dumb investing, but if Fund managers are unable to match or beat the Index they benchmark against , then why would any rational investor bother to place funds with them?
In the March 2017 Report of The Montgomery Fund it shows it has beaten the Index it benchmarks against since inception, however the Report also shows it has only marginally scrapped in over a four year period. Based on that one can conclude that the majority of the outperformance came in the early part of the Funds inception .
What matters now is how well the Fund will perform going forward and it’s upto you and your team to convince and show Investors that you can deliver . If your focus is on investing in the best Businesses then there should be no reason or excuses for underperformance . Over long periods of time Australian shares have delivered a return of about 6.7 % pa plus inflation. Inflation is currently running at about 2% and slowly rising, so in the current environment a Nominal Return of about 8.7% is desirable. Can TMF achieve that going forward? The answer lies in how well the Fund is currently placed valuation wise and how well that valuation is managed going forward.
Going forward you need to show Investors that you can deliver – excuses about sector rotation etc won’t cut it anymore – that was last years excuse. Investors expect outperformance against dumb Index investing – they will tolerate brief periods of underperformance but they will be unforgiving over extended periods. Don’t expect Investors to hang around for the next 10 years to see if your DCF valuations are justified.
I challenge you and your team to show us all what you can do and convince the doubters that Index investing is dumb investing.
Roger Montgomery
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So you are saying that junk can only beat quality stocks over one year and no longer? That we didin’t and won’t invest in cyuclical resources is not an excuse. It is a fact. Unlike you I have no idea which sector will outperform this year. I do know that over longer time frames quality has always, and will always, win. You’ll have to watch.The question is do you do that from the sidelines or as an investor.
Justin Smith
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Hi Roger,
Thanks for your reply. I still don’t really agree with you and yes of think you are cherry picking somewhat, and being unduly harsh about index funds in general. I agree there are some very bad ETFs and index funds, equally there are some terribly bad performing funds, and I’m not suggesting that yours are.
With regard to Buffet, in his most recent newsletter, he estimated that savers had wasted more than $US100 billion on Wall Street fund managers over the past 10 years and recommended that “both large and small investors should stick with low-cost index funds.”
In Australia, with such a terrible index, heavily weighted with a few very large cap companies, “the performance of active fund managers last year offered no resistance to the passive storm. In Australia there were 700 funds that couldn’t match the close to 12 per cent return generated by the S&P ASX 200 benchmark. On average they returned 9.2 per cent. Several active funds have closed or been reduced to a shadow of their former selves after clients withdrew money.” (Quoted from a recent article in the Fin Review)
The stable of low cost Vanguard index funds (founded by Jack Bogle) and their long term outperformance over most actively managed funds sort of discounts a lot of what you are saying about index investing just being dumb. If so why do so many supposedly very smart active fund managers consistently fail to beat this dumb index style investing, even in Australia where the index is so heavily skewed to some big banks, a couple of miners, telcos and grocery retailers!? Sorry but the corollary here is that if index investing is dumb, but most fund managers fail to beat the index, then what are the fund managers?!
I’m out of time, but as I alluded to in my earlier post, there are mathematical proofs by people much smarter than me and probably you, that show over a longer time period, with the drag of fees and costs and the fact that active managers also do pick quite a few “dogs” and miss the “stars”, active simply can’t win. Again I’m not bagging active. There is a place for it. But I think you’re being overly harsh and a little disingenuous about the better index funds.
Hey you’re a fund manager, I get it.
I’m not and I don’t have any vested interest, I even own a couple of your funds and a couple of dumb index funds, that have done very well.
Best regards
Justin.
Carlos
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Warren Buffett says most people will beat most fund managers by buying the S&P500 index and holding it for the long term.
Roger Montgomery
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And that may indeed be the case is the US Carlos. What he didin’t say was most people buying the ASX 200 will beat most fund managers. Take a look at the ASX200’s performance over the last ten years.
Chris
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It’s because you’ve now got too many ETFs from too many providers. Like flavours of ice cream, they’ve moved on from the ‘vanilla’ ETFs over the S&P500 or the FTSE100 to all of these exotic (and more expensive in terms of MERs) ETFs over indices that I’ve never even heard of. I would bet as well that most of these newer ones are carrying debt and / or are using derivates (“swaps”) as ‘synthetic’ ETFs, not merely being holders of the underlying stocks.
This is the same thing that happened in the GFC, in that derivatives were a major part of why markets collapsed and those people holding them took a massive haircut. Anyone remember watching “Understanding The Financial Crisis – Bird and Fortune” ?
I read some of the indices and I think “that’s just made up to suit that ETF, it’s not a ‘real’ index”. In having a constituent that is a “Dividend Growth stock” and a “Deep Value stock”, plus a play on “USA Quality Factors”and the US Dollar, they are trying to be the “ETF of Everythingness”. It’s a joke. I am very well read in terms of finance, but I lost interest when I heard them using terms like “tilt” and “thematic play”…it’s too complicated and too ‘out there’ for me.
Just like REITs, where they branched out overseas, put property development before property management and bought overseas property instead of just collecting rents, they got hammered when it all came to a head. The unfortunate thing is that when this happens, the plain vanilla ETFs will also get smashed.
Roger Montgomery
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Nicely put Chris and some interesting additional points Chris thanks. I had some tech issues approving Colin Weeks post. he wrote “One of the most insightful articles I have read in recent times
You do us all a service by posting this”
Justin Smith
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Hi Roger
I like a lot of what you write, it makes sense and you say it well. This article though I must say I find a little disingenuous, narrow focussed and I think you have cherry picked some ETF examples to support your view. You are after all a fund manager, and a lot of what you do is promoting your funds and getting new clients and new money. That I understand. You run a business.
I agree also that the Australian stock market capitalisation is dominated by a few very large companies that have shown very little share price increase over quite a long period of years.
I take umbrage though over your comment that “index investing is just dumb investing”. Fair go Roger! Jack Bogle, the founder of Vanguard and for that matter Warren Bufffett, whom you often quote, would also call you on this, disagree with you and much more eloquently than me prove you wrong!
There are mathematical proofs that show over time, with the drag of fees and costs, that most fund managers simply cannot beat a broad based index. When they briefly do for a period of time they tend to mean revert and then underperform for a period of time thereafter.
Add to that the mathematical fact of “positive skew” showing that if a fund manager misses those few companies in the index that have gigantic gains the fund will underperform. The index however would capture these, and yes also the dogs. However fund managers can sometimes be wrong, as often as they are right and seemingly great companies included in a portfolio also end up being “dogs”. Every fund has had them, including yours Roger.
Now don’t get me wrong Roger, there is a place for active management at times and in certain sectors. What I’m “having a go” at you about though is your somewhat biased, cherry picked article above and unfair generalisation that “index investing is just dumb”. Surely you are better than that!
I own a couple of your funds. I’m reasonably satisfied with their performance over the longer term but they only form part of my investing portfolio. When I originally invested in the Montgomery fund I also invested the same amount into a couple of broad based international ETF’s. Now they are not predominantly in the Australian and NZ markets so the comparison is not “fair” but they have performed significantly better, in fact one up 100%, without reinvesting distributions, over the same 4 year period. Case in point all ETF investing is not “dumb investing” Roger!
I hope you have the integrity to print this comment rather than consigning it to the waste bin.
Roger Montgomery
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Hi Justin, Thanks for your alternate view. I accept we may have a difference of opinion and I remain firmly of the view that index investing is dumb investing. Warren Buffett many years ago was advising index investing for the “Know Nothing” investing. That is, an investor who is not willing to understand business fundamentals. He recommended it as a strategy for his wife Susie in the event of his own death. Further, the fact that a market or and index is up 100% is not evidence of a superior investment framework. Indeed the story of the index return is most certainly not over and a subsequent correction or retracement is entirely possible. That said, the sell-off may not be evidence of inferior frameworks either. The point is that a rising market reinforces the behaviour that set it apace but the logic can still be wrong. With respect to the “cherry picking” you accuse me of, I referenced a lecture given by Steven Bregman at Grant’s Fall 2016 conference called The ETF Divide. The full lecture can be viewed using the link which follows and you will see there has been no cherry picking: https://vimeo.com/209940152/f2154e4d3d
garry howlett
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HI Roger,
Great article. Is it fair to say that If ETFs are programmed to just buy the underlying asset regardless of price to keep their weighting, surely if for some reason investors start to sell, then the programs will indiscriminately sell at any price. This is likely to have a magnifying effect especially in illiquid mkts where there are no bids.
Chris
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No need (necessarily) for retail individuals to sell, ETFs are designed on the “market maker” principle so that wholesale transactions CAN occur, i.e. securities will be bought / sold accordingly to provide liquidity.
I believe that this purely and of itself will move prices…the boon and bane of liquidity, being that liquidity was in short supply during the GFC when withdrawals from many unlisted funds were being frozen and other funds / equities (hello REITs) had to be recapitalised by massive capital raisings at deep discounts to the underlying net value (NTA) of the securities.
ETFs that rely on physical replication (i.e. they hold an underlying basket of shares or the commodity) will be less affected (but not unaffected) than those ‘synthetic’ ETFs which rely on derivatives and conversely, are not backed by physical holdings of securities or commodities. I see massive casualties amongst the synthetics because they don’t hold anything as collateral, which is why I’ve avoided them over all my time of investing in offshore ETFs since 2011.