Hope over experience?—S&P Indexology

I subscribe to the S&P Indexology blog.  It’s written by S&P staff involved in manufacturing the company’s well-known financial markets indices.  Usually it’s interesting, although the writers’ true-believer conviction that no active manager is capable of matching–to say nothing of outperforming–his benchmark index often shines through.

Yesterday’s post, titled “Hope over Experience, ” is a case in point.  It takes on a recent, pretty silly Wall Street Journal article that muses about an “Old-School Comeback”  of active stock mutual fund management, based on recent outperformance of the average active manager over the S&P 500.  “Recent” in this case means the first four months of 2015; “outperformance” means a gain of .33% versus the S&P.

The obvious observations are that the time period cited is extremely short and that the gain versus the index is probably statistically insignificant.  S&P Indexology goes on to say that the comparison itself is bogus. The S&P 500 is neither the appropriate or the actual official benchmark for many stock mutual funds, which have, say, growth, value, small-cap or other mandates and other benchmarks than the S&P 500.

So far, so good.

Then come two comments straight out of the university professor’s playbook:

–The first is the argument that because an active manager’s portfolio structure may be dissected, after the fact, into allocations that could have been replicated by indices, actually creating and implementing that structure in advance has no value.  That I don’t get at all.

–Indexology concludes by suggesting that because investing in the aggregate is a zero-sum game–the total winner’s pluses and losers’ minuses exactly offset one another, before costs–there can’t be any individual investors who consistently outperform.

I believe that life in general, and investing in particular, is a lot like baseball.  (I’ve been thinking about baseball recently because it’s in season).  The second Indexology comment is much like saying that the Giants’ winning three World Series in five years is a random occurrence.   …or that the change in ownership of the Cubs and the hiring of Theo Epstein have nothing to do with the club’s success this year.  Yes, bad teams get a preference in the draft each year, but the end to a century of futility?

…and what about the Braves and Cardinals, who consistently field above-average teams even though their draft positioning does them no favors.

To be clear, I’m an advocate of index funds.  My reasoning for this is not that outperformance is impossible (the ivory tower orthodoxy) but that it takes more time and effort than most people like you and me are willing to put in to locate and monitor active managers.  I’d be much more comfortable with Indexology saying this.

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.

S&P downgrade of US sovereign debt: investment implications

what S&P said

After the stock market close in New York last Friday, Standard and Poors’ Ratings Direct issued a research report in which it downgraded the long-term credit rating of the United States from AAA to AA+, with a negative outlook.

According to S&P, “negative outlook” means that there’s at least one chance in three that it will downgrade the US further within the next two years.

Short-term paper remains unaffected, with a A-1+ rating.

its reasoning

Two main factors:

–the rising public debt, and

–the fact that “elected officials remain wary of tackling the structural issues” in a way that AAA countries are expected to do (which I read as meaning that S&P regards government in Washington as a bunch of wannabe ballplayers wearing big-league uniforms and demanding big-league perks but who can’t hit the ball out of the infield ).

Apparently, the performance of all parties to the debt ceiling debacle was enough to make S&P revise down the opinion it formed in April.

who doesn’t know this already?

I think it would be hard to find any professional fixed income investor who isn’t aware the US has a debt problem.  In fact, over my thirty+ years watching the stock market, conventional wisdom (and actual experience) has always been that the rating agency opinions are lagging indicators of financial health.  To my mind, one of the crazier aspects of the sub-prime mortgage bubble is that professionals actually claimed they relied on the ratings, rather than doing analysis themselves–kind of like depending on last year’s calendar to tell you the day of the week.

As Casey Stengel would have commented, ” You could Google it.”   In round numbers, Washington has $2.5 trillion in annual income but spends $4 trillion.  Outstanding federal debt is already over $14.3 trillion, or about six years’ worth of gross income.  And that doesn’t count $40+ trillion in the present value of retirement and medical care promises Washington has made but hasn’t set aside the money for.

investment implications


There may be a day or two–if that–of negative reaction in both stocks and bonds to having the S&P shoe finally drop.  Otherwise, in the short term, I think there are no negative consequences.

Two other ratings agencies, Moodys and Fitch, have already reaffirmed their AAA rating of US sovereign debt.  So it’s unlikely that any large investor has a contract that will force it to sell Treasuries.

Besides, where else is there the same combination of liquidity and relative safety that still exists in Treasuries  …Japan?   …Italy?    I don’t think so.

In addition, as I mentioned above, this is scarcely a surprise.


This is much harder to handicap.

On the one hand, the downgrade will doubtless cause China to increase its efforts to create a substitute for the dollar as the global reserve currency.  As Xinhua, the Chinese news agency puts it, “The U.S. government has to come to terms with the painful fact that the good old days when it could just borrow its way out of messes of its own making are finally gone.”  In the same article, Xinhua also calls for international supervision of the issuance of dollar obligations, and the establishment of a substitute world reserve currency.

On the other,  Americans’ opinion of Congress is at an all-time (meaning since the Seventies) low, with 82% rating legislators unfavorably.  The New York Times, a Democratic bastion, just ran an op-ed piece arguing the country would be better off with Richard Nixon as president than Barack Obama.

It’s at least possible that the embarrassment of a national credit downgrade after 70 years of AAA will sharpen political debate and influence the next national election–coming in November 2012.  The groundswell appears to me to be already taking form.  If so, the public outcry may well influence, in a favorable way, the recommendations of the congressional committee being established to make budget-balancing recommendations as part of the debt ceiling deal.

Who knows.

I also think this event brings us closer–both in time and value–to a buying opportunity in world markets.  Today will be an interesting day to watch closely.

S&P revises its outlook for T-bonds from stable to negative

The S&P announcement

Yesterday the rating agency issued a new “unsolicited” opinion (meaning it wasn’t hired by the US to do so) on US government debt.  While retaining its current AAA rating for Treasuries, S&P has revised down its outlook for the country’s long-terms obligations from stable to negative.

What does this mean?

“Negative” means S&P thinks there’s at least a one in three chance of a credit downgrade within the next two years.

S&P’s reasoning?

The factors S&P considers most important are:

–deterioration of the US fiscal position over the past decade

–damage done by the financial crisis and ensuing recession

–inability of Washington to agree over the past two years on a plan to address these issues

–the “significant risk” that nothing will be done before the election in November 2012.

Although S&P (like everyone else) regards unfunded entitlement programs Social Security and Medicare/Medicaid as the main sources of budgetary woes, it points out that the country may also have to cough up another $685 billion to recapitalize Fannie Mae and Freddie Mac.  S&P observes, as well, that much of the US sovereign debt is concentrated in the hands of a small number of foreign governments, raising the possibility that one or more might change their minds.

be careful what you wish for

It wasn’t that long ago that Congress was lambasting the rating agencies for not being proactive enough in downgrading the exotic credit instruments spewed out by Wall Street.  Their collapse weakened the national finances and made the deficit a “today” issue rather than one that could be safely be put off.

I wonder how Washington likes proactivity now?

And the S&P raters whose integrity was questioned by Congress wouldn’t be human if they didn’t take a kind of satisfaction in calling attention to the fact that the UK–and even France (?!?)–are further along the path to fiscal responsibility than the US.

what happens next?

A lot depends.  I don’t think there’s much anyone can say for sure.

For one thing, not everyone agrees that the S&P analysis is correct.  For example, a comment popped into my inbox at about 6pm on Monday from Jim Paulsen, the chief economist for Wells Capital, arguing that the deficit is primarily cyclical.

It seems to me, though, that the S&P announcement puts additional pressure on elected officials to cooperate with one another.  That pressure would increase if, say, Moodys, were to follow the S&P lead and say something similar.  The debate on raising the federal debt ceiling will give an almost immediate indication of whether the Democrats and Republicans can work together.

No matter what, my guess is that the S&P announcement will turn out to be a significant turning point for US government finances.  Despite the dollar being the world’s reserve currency, I think the days of Washington just willy-nilly issuing news bonds are coming to an end–sort of like maxing out an almost infinite credit line.

Also, if past form holds true (and I think it will), domestic borrowers–not foreigners–would be the first to desert the Treasury market in large numbers.  This means that worry about Treasuries will express itself initially, and primarily, through higher interest rates, not a weaker currency.  Only if the situation becomes really ugly will the dollar come under significant pressure.

From an overall economic perspective, I find the “hidden” loss of wealth through currency depreciation to have worse negative effects than adjustment through higher interest rates and a slower economy.  From a stock market point of view, however, it’s much easier to devise a money-making strategy in a weak currency environment than in a high interest rate one.

Stay tuned.