Category Archives: index funds

the FT, Vanguard and Morningstar: active vs. passive investing

July 14, 2014 By in Academic Theories, index funds, indexing Tags: , , , Leave a comment

Saturday’s edition of the Financial Times opens with a screaming front-page headline, ” $3.5 billion pulled out of Fidelity funds.”  

 …must have been a slow news day.  

The article goes on to explain that net inflows of individual investor cash into the stock market–both in the EU and the US–over the first half of 2014 have been going to index products, not to active managers. 

I can see several good reasons why this is so:

1.  Indexing is like cruise control.  You know you’re going to get more or less the return on the index against which a given index fund/ETF is benchmarked.  So you only have two variables to consider:  how closely the fund/ETF is able to track the benchmark, and what its expense ratio is.  There’s no fretting about an active manager’s style and strategy, or whether he/she is still running the portfolio whose historical record you’re examining

2. Fidelity doesn’t necessarily want mutual fund customers.  I’ve had a Fidelity brokerage account for decades.  Fidelity has never approached me, ever, to buy a mutual fund product of any type.  I presume it’s because the company makes more money from having me trade individual stocks.

3.  Picking active managers takes some effort.  It requires having some understanding of the stock market and an ability to deduce strategy from the lists of holdings that managers report each quarter to the SEC.  

True, there is Morningstar, a service which has been providing its famous “star” rankings of mutual funds for about a quarter century.  Although Morningstar, disingenuously, warns buyers of its star information not to use it as the reason for picking a given mutual fund, people do pay for the rankings.  So they must have a reason.  Investment management companies take out full-page adds to tout their high star-ness.  Inflows seek high-star funds and shun low-star ones.

Over at least the past several years, however, Vanguard points out that following Morningstar rankings hasn’t been a good idea.  The index fund giant is publicizing a study it did of Morningstar fund rankings from 2011 – 2013.  Over the three years, Vanguard says there was a strong correlation between Morningstar star ranking and fund performance, but it was the opposite of what the rankings suggested.  One-star funds performed the best vs. their peers, two-star funds the next best   …and so on, in order, with five-star funds performing the worst.  Whoops!

Personally, I’ve never been a fan of Morningstar’s use of short-term volatility as a measure of the riskiness of a portfolio.  My guess is that the relative stability of a fund’s NAV ends up being the most important factor in getting a high star rating.  So that rating has little to do with future return potential.  But I have no real idea how Morningstar could have gone as badly astray as Vanguard says.

Anyway, to sum up, if there’s any news in the FT article, it’s the (understandable) extent to which individual investors are embracing psssive investing, not the fact that they’re doing so.

 

 

 

securities analysis in the 21st century: fifty years of changes

September 19, 2013 By in Current Market Thoughts, Getting financial advice, index funds, Industry Analysis, Investment firms, Portfolio management, using research Tags: , , , , , , Leave a comment

Fifty years ago, the financial services industry in the US was a backwater, somewhere people went to work if they couldn’t find a job elsewhere.  But powerful changes were on the cards.  Americans were becoming wealthy, at least in part because the country’s industrial base was the only one in advanced economies left standing after World War II.  And they were developing an appetite for stocks.

reasons for rapid growth of financial services during 1970-90

–the maturing of the Baby Boom

–1974 ERISA legislation, which more or less compelled companies to hire competent third parties to manage their employees’ pension assets

–ERISA also established IRAs

–1978 tax legislation established 401ks

–the rise of discount brokers and no-load funds (even in the 1980s, load funds charged purchase fees of up to 8%) that made investing cheaper and easy

–the crash of 1987, which, I think, caused a fundamental shift by individual investors away from traditional brokers and individual stocks, to mutual funds

–a shift in the 1990s, motivated by wanting to reduce their legal liability, by traditional brokerage houses to convert brokers from “stock jockeys” into salesmen of packaged products like mutual funds

The result of all this was the spectacular rise of the money management industry during the second half of the last century.

seeds of decline

–downward pressure on commission rates

ERISA requires that when money managers transact, they obtain the best execution (buying/selling price) as well as the lowest transaction cost.  As technology developed, this meant that trading rooms had a legal obligation to use electronic crossing networks (“dark pools”) instead of routing orders through traditional brokers. Fidelity was a leader in this.

The move also had the positive side effect of denying brokers to opportunity to use client trading information for their own benefit–either by trading on it themselves or by blabbing about it to other money managers.

–questioning of “soft dollars”

money managers routinely buy information from research organizations, including brokers, by allowing them to charge commissions that are 50%-100% higher than normal (called “research commissions”).  Fidelity, the industry standard of best practice, has been working for years to restrict the amount of shareholder money that is being spent this way.  Yes, this is good for Fidelity–by being bad for smaller rivals.  And its efforts have been very effective in cutting the diameter of the firehose spraying commission dollars at research sources.

in recent years, there’s been a small but growing trend for big clients of money managers to demand that a portion of their soft dollar allotment be earmarked for buying services for the client, not the money manager

–the move to index funds, and ultimately to ETFs, which don’t require active management

–massive redemption of equity mutual funds during the Great Recession, reducing further the assets in the hands of active managers.  Since managers are paid a percentage of the assets they oversee as their fee, fewer assets means less money to pay employees like securities analysts and portfolio managers

–large-scale firings of experienced securities analysts by brokerage firms during the Great Recession.  Over the course of my career on Wall Street, brokerage companies have been gradually changing themselves into trading firms–because, rightly or wrongly, they regard trading as much more profitable.  They’ve been laying off experienced analysts for over a decade,  disgorging even the most deeply entrenched during 2008-9.

The net result:  the big brokerage research departments of the 1980s-90s are gone.  There may be bodies occupying seats today, but they generally lack training, supervision and experience.

Active managers, who had cut back their (mostly ineffective) research staffs in the 1980s,  in favor of buying information from brokers with soft dollars instead, have few internal assets to rely on.  They also have lower fee income.  Are they going to rebuild their own research?  If so, whose current pay gets cut?  Will new research be any better than the sub-par operations they ran last time around?

for individual investors, like you and me…

THIS IS GREAT!!!

Yes, less well-informed institutions means that day-to-day volatility may be higher.  But it also means that we have a much better chance than we did a decade ago to discover valuable information that Wall Street doesn’t know yet.

Tomorrow, what companies are doing–with an aside on AAPL.

housecleaning at the Dow Industrials

September 11, 2013 By in Dow vs. S&P, index funds, Keeping Score, Portfolio management Tags: , , , , , , Leave a comment

Standard and Poors, the part of the McGraw Hill empire that controls the Dow Jones averages, announced today that the Dow Industrials would be bouncing out three of its thirty components, effective September 20th.

The companies to be shown the door are :  Alcoa (AA), Bank of America (BAC) and Hewlett-Packard (HPQ).  Their offense?   …stock prices that are too low, and not enough diversification appeal.

They’re being replaced by:  Goldman Sachs (GS), Visa (V) and Nike (NKE), all of which have higher stock prices and supposedly give the Dow more diversification.

We all know the Dow is a weird index.  That’s because it’s calculated using each stock’s per share price (not the total value of the company’s equity) as the weighting factor.  So a stock that sells for $50 a share has twice the potential impact on the index of a stock that sells for $25–even though the latter may be a much bigger company, with a much larger total market value.

No wonder Alcoa, an $8 stock, and Bank of America ($14.60) are gone.  They’re insignificant!

No surprise, either that Apple ($494) and Google ($888) aren’t in.     …too large.

Why calculate an index this way?  The only answer I can come up with is that in the (computer- and calculator-less) late nineteenth century, when the Dow was invented, the math was simple enough for reporters to get done quickly at the end of the day.

Why does it still exist?   …and why do individual investors still pay attention?  At first blush, the answer is that the Dow is almost all the news media talk about.  But the media would ditch it in a second if the Dow weren’t a surprisingly good mimic of the more sensibly constructed S&P 500, which is what investment professionals use as their benchmark.

Think about it for a minute (something I haven’t done until recently).  What are the chances that a small, wacky index can track the S&P 500 so closely?

As I recall, it wasn’t always this way.  Back in the day, investors tracked the Dow vs. the S&P.  If the Dow was doing better, it meant the ghost of Christmas past was in the room.  If the S&P was outperforming, then smaller stocks in less mature industries were on the relative rise.

Not so much anymore.

It seems to me a tremendous amount of brainpower and computer time has recently gone into–and continues to go into–tuning the Dow Industrials so that they’ll keep on tracking the S&P pretty faithfully.  That’s the really interesting thing about the Dow, to my mind.  And it’s the reason AA, BAC and HPQ had to go–not for diversification, but because they weren’t helping the Dow track the S&P.

Verizon (VZ), Vodafone (VOD) and flowback

September 10, 2013 By in flowback, hedge funds, index funds, internet, Stock ideas, Technology, Wireless Tags: , , , , , , , , , , , Leave a comment

VZ is buying the 45% of Verizon Wireless that VOD owns.

VZ, which owns 55$ of Verizon Wireless, recently agreed  to buy the other 45% from VOD for around $130 billion.

From what I can tell so far, the deal will be good for VZ.  And, at the very least, VOD gets a boatload of cash and stock.  In hindsight, VZ would have been a lot better off striking the same deal in March, before the Fed began hinting that it was thinking of ending the current post-recession period of extra-super-accommodative money policy in the US.  The interest rate VZ would have paid on newly issued bonds would have been lower.

More on this topic in future posts.

There may not be a great need to load up on VZ ( which I own) immediately, however–even if you think the deal is a spectacular coup for VZ (too enthusiastic for me).  The reason is flowback.

what flowback is

VZ is going to issue over a billion shares of new stock to VOD as part of the purchase price.  VOD has already announced it will distribute to its shareholders all of the VZ stock it receives.  That’s something like one VZ share for every 40 VOD shares held (the exact ratio isn’t important).

What is important is that VOD is a UK corporation whose stock is traded in London.  The bulk of its shares are held either by UK or Continental European institutions.  US institutions hold only about 15%.

Put another way, early next year almost everyone who owns VOD will receive shares in a foreign stock, VZ.

What will they do with it?

For index funds, the answer is clear.  If it’s not in the index, it has to be sold.

For institutional managers in the EU, the answer depends, in the first instance, on what their contracts with customers say.  They’ve presumably been hired for their expertise in EU equities.  Management agreements probably stipulate that they’re not allowed to hold non-European securities.

Even if they are permitted to hold VZ, why do it?  Why take the risk of holding a stock that’s outside your area of competence–and which will require considerable research effort to get a firm grasp on.  Selling is a much safer option.

For individuals, if form runs true, the first they’ll hear of the deal will be when their broker calls to tell them that shares of VZ have plopped into their accounts–and to urge them to get rid of this weird thing.

That’s flowback.

It happens in all cross-border deals that involve stock.  When shares of the issuing company leave the home country, some portion will be sold immediately by investors who are unable or unwilling to hold what is for them a foreign stock.

Where do these sales take place?   …ultimately in the home market of the issuer.

the VZ case

For VZ, average daily trading volume is around 10 million – 12 million shares.   Occasionally, volume can get as high as 30 million- 40 million shares without moving the stock too much.

Let’s make up a number and say that flowback will be 300 million shares.  That’s easily an entire month’s trading volume.  So this could be a serious issue for VZ’s price.

mitigating factors

There are three that I see:

–Verizon Wireless is the largest and most important asset for both VZ and for VOD.  Non-index investors in the EU must have wanted exposure to Verizon Wireless to be holding VOD shares.  Arguably, they will want to continue to have that exposure and will therefore be less inclined than normal to want to sell.  So maybe some will be able to wangle exceptions from their clients.

–trading volume in VZ over the past seven trading days (not including today) has averaged about 25 million, or–let’s say–12 million shares above normal.  If this is all merger-related short-selling, which it probably is, then this trading has already created demand for 80+ million shares of VZ when the shorts are covered.

–the stock has a current dividend yield of 4.6%.  At some point, this and other VZ fundamentals should provide price support.

my take

Worries about flowback are one reason large cross-world acquisitions involving stock aren’t that common.  This one was clearly too big for VZ to do any other way.

My guess is that anticipatory selling in advance of the acquisition will make it hard for VZ to go up for a while.  I also think, however, that downward pressure from potential flowback will abate long before the deal actually occurs.

At some point, an excellent buying opportunity for VZ will emerge from acquisition-related stock activity.  The trick is deciding exactly when.  The most prudent strategy, I think, is to establish a small position and await further developments.

 

 

how are your mutual funds doing?

June 4, 2013 By in Constructing a Portfolio, Getting financial advice, hedge funds, index funds, Portfolio management, securities markets Tags: , , , , , , , Leave a comment

the SPIVA scorecard:  index funds rule!

Standard and Poors did a major overhaul of its website a while ago.  I’d been delaying getting familiar with the new layout while the old site still held the information I usually look for.  But S&P shut down the old page with monthly performance on it, and I was forced to move too.  I eventually found the performance data, but while I was poking around, I also stumbled across a SPIVA (S&P Indices Versus Active Funds) Scorecard report for yearend 2012.

The scorecard tally?  …about what you’d expect.

Over the three-year period 2010-2012 (all bull market) and the five-year period 2008-2012 (includes both bear and bull periods), the typical equity fund and thee typical bond fund underperformed its benchmark index.

Three exceptions:

–the median small-cap international fund outperformed its benchmark.  This is a small category, however, and all the outperformance seems to have come from having a rip-roaring 2013.

–the median large-cap value fund also outperformed.  Unfortunately, the S&P 500 Value index lagged the S&P by an average of 180 basis points a year over the past half-decade.  Actively-managed large cap value funds performed more or less in line with growth-oriented funds and “core” funds that compete against the plain-vanilla S&P 500 rather than a style-tilted version.

–investment-grade intermediate bond fund managers outperformed as well.  But, like the value equity managers, they had the weakest benchmark.

fewer funds

Over the past five years, almost 27% of the domestic equity funds either merged with other funds or simply liquidated.  23% of international equity funds did the same, as did 18% of fixed income funds.  These were presumably the ones with the worst performance records–the fund industry burying its dead, as it were.  That’s also a huge percentage.

why hire an active manager?  why not index?

For almost everyone, in my view, indexing is the way to go.  It’s the cheapest.  Because your focus on getting exposure to the asset class (stocks) at the lowest possible cost, fewer things can go wrong.  This means less time, effort and skill needed on your part to monitor this part of your overall portfolio.

Why don’t more people index?

–It’s kind of boring.  Just look for the biggest index fund (it’s Vanguard).  It’ll have the lowest costs and the most faithful mirroring of the index.  And you’re done.

–Some people have motives other than making money for being in the stock market.  Some actually like risk for its own sake, believe it or not.  Others want to feel special or be the center of attention at parties.  They likely also want the $200 oil change at the Mercedes dealer (where you get coffee and a bagel, too), not the $30 deal at Jiffy Lube.

–Many financial advisers dislike index funds.

There are typically no trailing commissions (recurring payments from the fund management company while a client continues to hold the fund).  No information seminars or reward meetings, either.

Suppose I’m your adviser and I say, “Let’s take the $1 million you’re allocating to stocks and put it in the Vanguard S&P 500 index fund.  We’ll leave it there forever.  By the way, I’m charging you $1,000 a month ($2,000?), again for ever, for this advice.”  At some point, you’re going to baulk.

More than that, because they charge high fees, actively-managed fund complexes have big marketing budgets.  And, unless they have a huge indexing operation, they don’t have cost-competitive index products.  So almost all the ads you see are for active management.  A lot of them air on financial news shows on cable.  Fat chance the talking heads will tout indexing.

one consolation for holders of actively managed funds

At least they’re not hedge funds, which continue their decade-long record of underperformance of traditional equity managers.