the new S&P 500 sector arrangement

Keeping Score tomorrow

a new S&P 500 sector breakout

Announced last November, a new S&P sector arrangement went into effect last Friday.

Telecom, with only three constituents and about a 2% market weighting, disappeared and was replaced by the new Communication Services sector.

The latter contains former telecom names + enough heavyweights from IT (e.g., Facebook, Alphabet, Activision, Electronic Arts) and Consumer discretionary (e.g., Disney, 21st Century Fox, Comcast, Netflix) to give the new sector a total of 26 constituents and about a 10% market weighting–clipping a total of eight percentage points from IT + Consumer discretionary.


revised overall sector weightings:

IT .    21%

Healthcare .    15%

Financials .         13.3%

Consumer discretionary .         10.3%

Communication services .         10%

Industrials .         9.7%

Staples .         6.7%

Energy          6.0%

Utilities .         2.8%

Real estate .         2.7%

Materials .         2.4%.


my thoughts

–Telecom was a mature sector–if sector is the right word for three stocks–with large, high-dividend companies in it.  So it had defensive characteristics.  Not Communication, though, which contains a bunch of high-multiple, low/no yield components.

–The old Wall Street saw is that any sector is in for big trouble when it breaches 25% of the S&P 500’s weight.  That’s no longer the case with IT, but the change is obviously artificial.

–Splitting the index  sectors into highly cyclical, somewhat cyclical and defensive comes out like this:

Highly:  Materials, Industrials .  ~12% of the S&P

Defensive:  Real Estate, Utilities, Staples .   ~12% of the S&P

Somewhat cyclical:  everything else.      ~76% of the S&P.

Nothing has really changed, but parsing it out like that makes the index look like it has almost no defensive characteristics.  The lower weight for IT makes the index look less risky: this does the opposite–if only by about 2 percentage points.

–There’ll be new passive ways to bet on the Communication sector



index fund gains in the US

According to a survey reported in the Financial Times and done at the newspaper’s request by Morningstar, assets in US index mutual funds now comprise a third of total domestic mutual fund assets.  That’s up from 25% this time three years ago.

Nevertheless, actively managed assets under management have risen by 14%, despite the market share shift.  So the fees being collected by active managers are up.  This is doubtless due mostly to the fact that markets have been rising.  The S&P 500 is up by about a third over the three-year span, the Bloomberg Treasury index by 12%.  Watch out, though, if markets flatten or begin to decline.


More bad news:  the FT is reporting that 90.2% of US active equity managers underperformed their benchmark, after deducting fees, over the twelve months ending June.  Not numbers that will stem outflows.


Since I’m getting such an unbelievably late start today, I’ll only make two points:

–in the investment organizations I’m aware of, management control is in the hands of professional marketers, not professional investors.  I think their giving a much higher priority to selling rather than making products is a substantial part of the underperformance problem for these firms.  It’s highly unlikely, I think, that marketers will volunteer to step down and turn the reins over to makers.  So I expect underperformance issues will continue.  If I’m correct, the next bear market could prove crushing for these organizations, since the combination of falling prices and client withdrawals will doubtless mean sharp declines in profits.  Where will the money come from to beef up research and portfolio management operations then?

–some large investment management firms known for active management are reported to be finally entering the index fund market themselves.  First of all, this seems to me to show the marketing bent of their managements, giving support to my first point.

In addition, index funds have very large economy of scale effects and the oldest/largest have been in existence for decades.  Because of this, I can’t imagine that Johnny-come-lately firms will ever have profitable index offerings.  The firms may subsidize their index funds  so that the fees for you and me will be on a par with bigger rivals’, but I don’t see how the subsidies can ever be taken away.  Yes, such firms may retain assets, but their bottom lines will be worse off than if they retained them.

how are your mutual funds doing?

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.

stock indexes and indexing

what stock indexes do

Stock indexes have two main functions:

1.  They provide information about how stocks in general are doing.  Part of this is that it’s nice to know, sort of like the weather. But that’s not all.  The broad stock market has an important role in macroeconomic forecasting.  In the US, the stock market is historically the most reliable leading indicator of economic activity.  Even in today’s world where half the market’s profits come from abroad, changes in stock market direction tend to accurately foretell changes in economic growth that occur around six months later.

2.  Indexes serve as measuring tools to assess the performance of professional money managers.  Three factors have made the role of benchmark increasingly important:

–the widespread rise, post-WWII, of pension plans for workers,

–The Employee Retirement Income Security Act (ERISA).  This Federal legislation, passed in 1974, set down strict standards for corporate stewardship of employee pension plans, and

–rising affluence, which has transformed stock market investing from the exclusive province of coupon-clipping bluebloods into an arena where middle-class Americans can, and do, participate.

academic research on active management

Most of the finance taught in universities is pure nonsense, in my view.  The real world is much more complex than professors realize.  Nevertheless, academics do do good empirical research studies.  One of their most devastating findings is that the typical professional, or “active” investment manager in the US routinely underperforms his benchmark index.  Almost no one outperforms after deducting the fees he charges for his services.   Ouch!  (As it turns out, my portfolios generally outperformed, but I usually ran portfolios that had large exposure to foreign markets–which are another story).

Once ERISA forced pension funds to pay attention, they quickly learned this lesson.

Hence the rise of index funds, which track very closely the performance of benchmark indexes like the S&P 500 and have extremely low costs.  That’s “low” in the sense of better performance than an active manager, at far less than 10% of the costs.

lots of index providers

Standard and Poors has a whole slew.  So does the Financial Times.  Pension consultant Frank Russell has a bunch, too.  And MSCI.

Why so many?  

–They’re profitable.  They’re also relatively easy to set up.  All you need is the money to hire a few quants and a giant computer.

–The first guy in collects the most assets.  Therefore, unless he really messes up, he should have the lowest costs.  And as a result of that, he should get the majority of new inflows.  So it’s much, much better to have an index fund product a little in advance of any demand.  Being late to the party is devastating.

they’re all a little bit different

The FT index for large-cap US stocks has somewhat different constituents from S&P’s;  both are different from Russell’s.  That’s to make it more expensive for large institutional clients, who may pay only a few basis points per year in fees, to switch among index fund providers.  So they can’t play one provider off against the others and bargain for lower fees.

More tomorrow.

index funds, passive ETFs and operating leverage

Russell leaves the ETF business

Early this month, the financial press carried stories that Russell Investments, the pension consultant turned money manager, has decided to close its ETF business less than two years after entering the field.

What’s going on?

(By the way, Russell’s is the typical pattern in many commodity-like industries, where latecomers are never able to achieve the scale needed to become profitable.  Presumably, Russell knew this before made its move into ETFs.  It concluded that the possible gains justified the initial outlays.  On the other hand, maybe it didn’t.)

the case for passive products

Arguably, given the repeated failure of active managers in the US equity market to outpace the S&P 500, or other standard benchmarks, passive products are better choices.

At the same time, with passive ETFs or index funds, the possibility–however remote–of market-beating performance is eliminated as a selling point.  Every fund targeting the same benchmark index will have (more or less–a comment on this in a minute or two) the same gross return.  As a result, the only real difference among funds is the size of the fees the fund operator charges.  Lowest fee wins.

basic assumptions

Let’s look at the situation as if we’re a newcomer to the passive fund industry.

We’ll have expenses:

–for a bank to keep custody of assets

–for mathematicians to oversee construction of the portfolio and to monitor the trades the fund makes to deal with purchases and redemptions

–for traders to buy and sell the securities in the fund, and to process customer orders

–for overhead, that is, office space, marketers, boards of directors, lawyers. top management…

To make the numbers easy, let’s say all that costs $1 million a fund a year.  (Unless a firm plans on having a ton of funds, $1 million is going to be much too low.)

Let’s also say that once we have all this infrastructure in place, the variable cost of running a given fund is the electricity needed to power the computers that keep the fund humming.  Call that zero.

charging for our services:  the view from below

Now we’re ready to offer our products to customers.  Customarily we charge a percentage of the assets as our fee.  How do we set that percentage?

well, our fund has to be at least reasonably competitive with other offerings in the market.  Let’s say the most prominent fund among our rivals charges a fee of $.20% of assets.  If we match that fee, then we’ll only achieve breakeven when our assets exceed $500 million.  Until we reach that level, we’ll have to subsidize our operating expenses.

Our other choice is to charge a higher fee, at least initially.  But since low price is the major selling point for the product, it’s not clear that this will be successful.

Worse than that, there’s a second issue with passive products–the question of how faithfully a given index fund or ETF mimics the benchmark it intends to duplicate.  This is called tracking error.  Passive portfolios don’t usually buy and sell tiny bits of all the stocks in their benchmark.  They transact in small, more liquid subsets of the index that their statistical analysis says will mirror the overall index closely.

Assurance that tracking error is low comes partly from the fund promoter’s promises, but mostly from seeing the fund deliver on those promises over long periods of time.  A startup fund only has the first.

It’s going to be hard to attract assets away from the market leader who has a low tracking error by charging more.

the view from the top

Look at the market leader.  He’s getting in new money on a regular basis from IRA or 401k clients.  If the relevant index is up, say, 20% over the past year (the S&P is a tiny bit better than that), his assets under management–and therefor his management fee–have gone up by that amount just by not losing net customers.  So the market leader is making at least 20% more money than he was in 2011.

What’s his best strategy?  Cut his management fee percentage, of course!

If the market leader decreases his management fee to .175% of assets, he’s still making more money than before.  His product looks even more attractive.  And he’s forcing the startup to cut management fees, too–raising the startup’s breakeven to $570 million, thus lowering the chances that the startup will ever reach profitability.

more wrinkles

There are a few.  But I’ve made my main point–that unless the market leader gets piggish and creates a pricing umbrella under which the competition can prosper–it’s tough for a latecomer to gain any market traction.  That’s natural market evolution.  And it’s what has happened to Russell.

That’s it for today.