(CC image by Core Media Product Demo on Flickr)

(CC image by Core Media Product Demo on Flickr)

 

If you trade stocks, you’ve heard it before.  We all have.  From a colleague, family member, friend, or a mainstream investment advisor.

“You can’t beat the market.”  “Picking stocks is a fool’s game.”  “Stick to low-cost index funds.”  “Buy and hold for the long run.”

The list of prominent names who advocate for passive investing over active investing includes, to name just a few:

  • Jack Bogle, founder & former CEO of Vanguard Group;
  • Warren Buffett, founder & CEO of Berkshire Hathaway, who bet $1 million that a basket of 5 hedge funds would not beat an index fund;
  • Burton Malkiel, Princeton economist and author of Random Walk Down Wall Street;
  • Dave Ramsey, radio host and author of personal finance books including The Total Money Makeover. (Dave seems to be OK with actively managed funds, as long as you don’t do anything besides buy-and-hold the fund)

These folks would have us believe that the recipe for building wealth through investments is the following:

  1. Shovel money into low-cost indexed mutual funds and exchange-traded funds (ETFs) that mimic a broad market index, such as the S&P 500, FTSE 100, Euronext 100, DAX, or the S&P/ASX 200.  Or better yet, a global fund that includes all of them.
  2. Sit and wait for many years, while trying really hard not to look at your broker or retirement provider’s statements, lest you be tempted to sell.
  3. Retire rich.

Sounds simple, right?  It is!  Being somewhere between “mediocre” and “below average” isn’t too tough, if that’s your goal.

Why “below average”, not average?  If you hold a broad market index, aren’t you achieving the same return as the average market participant?

No.

 

Why holding index funds puts you at a disadvantage

Some companies perform better financially than other companies.  (Duh!)

There are exceptionally well-run companies, terribly-run companies, and many in between.  As a passive investor, you’re the last to discover which are the good ones and which are the bad ones.  Active investors are constantly researching these firms to separate the wheat from the chaff.  Accordingly, they bid up the prices of the stronger ones and sell the shares of the weaker ones, so that over time their market values move in the right directions.  This process generally happens over a period of time, with the first movers getting the rewards for their work and the late movers stuck on sinking ships or chasing trendy companies that have already reached stratospheric levels.

Some companies are a disaster waiting to happen – a powder keg that will blow a hole in the value of your portfolio.  What if you could avoid them?

As an example, let’s examine the performance of the Energy Select SPDR Fund (XLE) starting with the major peak that occurred on July 24, 2014.  This fund is the largest ETF tracking the energy sector.

The chart below illustrates the XLE (the black line) and ten of its largest holdings (the colored lines) in 2014, all indexed to a starting value of 100 for clearer comparisons.  The XLE fell by over 40% to a low in January 2016, followed by a recovery of about half its losses.  However, all energy stocks are not created equal.  A sharp investor could have avoided the pain, or even experienced gains during this tumultuous period.

xle-2014-16

After initially being sold off alongside the rest of the sector, independent refiner Valero Energy (VLO) had vaulted to a gain of over 50% by the end of 2015, thanks to strong refining margins, low debt, and productive capital investments.  Refiners like Valero actually benefit from declines in the price of oil, the raw material for its refineries, as long as profit margins hold steady.

Other components of the XLE fared better than the index, including Exxon Mobil (XOL) (10% decline) and EOG Resources, Inc. (EOG) (15% decline) compared to a 29% decline in the XLE as a whole.

On the flip side, Chesapeake Energy (CHK) collapsed, shedding 90% of its value and dragging down the energy ETF along with it.  The natural gas producer suffered steep drops in the value of its shale assets, many of which could not produce at a profit as oil and gas prices plunged.  It continues to suffer under the burden of substantial debt.

You didn’t need to be a professional investor to see the potential for huge differences in how these companies would perform.  Two tools – (1) a simple stock screener filtering on debt levels and (2) an understanding of the basic differences between a refiner, pipeline company, an explorer, and a producer – would have helped you hang on to 15 or 20 percent of your investment that would otherwise have been lost in XLE.

But because index funds have all the stocks, and there tend to be more winners than losers, it all works out in the long run, right?  Wrong, because…

Most indexes are capitalization-weighted

What does this mean?  Each stock’s share in the fund is proportional to its market capitalization (the price per share multiplied by the number of shares outstanding) relative to the market capitalization of the index.  So, the stocks that make up the highest weight in the index are the ones that have already been bid up by the market to the point where they are worth more than the others.  By investing in a fund that mirrors one of these index, you’re piling into the stocks that already have reached celebrity status.  You don’t own tomorrow’s Amazon or Facebook, or enough of it to matter, because they are too small today to get much (or any) weight within the large ETFs.

For some companies with strong cash flows and well-established business models (think: Exxon Mobil, Wal-Mart, Boeing), high valuations can make sense.  But for every one of those, there is an overvalued dud.  Remember Enron, Eastman Kodak, Woolworth’s, Trans World Airlines, Pan Am, WorldCom, RCA, Compaq, or Pets.com?   At one time, each of these was a hot stock with a very high market capitalization, but now they are all confined to the history books.  Which of today’s high flyers will join that infamous list one day?  Apple?  Volkswagen?  BP?   All of the above?

The “illusion of diversification”.

It is easy to be lulled into a false sense of security by thinking you are diversified because you hold 20 or 30 of the biggest publicly traded companies in a sector instead of just one.  But, it’s typical for the largest 4 or 5 to comprise over half of the weight in a sector ETF.

What about holding all the sectors?  If you own many retailers, chemical companies, oil refiners, banks, wireless providers, technology firms, and mining companies, surely that is enough diversification?.  In 2008 and 2009, that didn’t work so well.

S&P 500 Index, from 2006 to 2009

S&P 500 Index, from 2006 to 2009

 

Correlations between different stocks and sectors always increase during times of financial stress – which are precisely the times when you need true diversification the most.

Another way of saying this is that when the markets are panicked, everything gets sold – the baby, the bathwater, the tub, the copper pipes in the bathroom, the house itself, and the land it rests on.  Imagine if you had just retired in 2007 with a “diversified portfolio” full of stocks.  By 2009, half your assets had vaporized.

True diversification requires owning multiple asset classes, including alternative assets, in proportions that are optimal for today’s investing environment.  I also encourage investors to consider using options to manage portfolio risk.  This will be a topic for future posts.

 

ETFs are more popular than ever, creating opportunity for active investors

Hedge funds are closing at an increasing pace.  Institutional money managers and individual investors are flocking to ETFs in record numbers.  Since gaining mainstream status in the 1990s, index funds have captured a larger share of overall stock assets nearly every year since 2000, according to CNN Money.  There are over 1,000 ETFs today, with new ones released every week.  They track a mind-boggling number of indexes, with tongue-twisting names like the “Dow Jones FEAS Titans 50 Equal Weighted Index” and the “Dow Jones Europe Developed Markets Select Real Estate Securities Index.”

This article, from Julia La Roche at Yahoo Finance, is a reminder of how dangerous this phenomenon can be for buy-and-hold index fund investors.  In it, independent researcher Steven Bregman warns of an “indexation vortex that’s distorted clearing prices in every type of asset in every corner of the globe.”  He emphasizes the systemic risk that ETFs pose, an argument that has become more mainstream lately as ETF “flash crashes” become a more common occurrence.  But I’d like to focus on what I feel is the critical point here – the tremendous opportunity the ETF boom provides to active investors.  That is, the “golden age of active management.”

Every dollar that moves OUT of an active fund (e.g. hedge fund or actively managed mutual fund) or an active strategy-based approach INTO a passive, indexing plan puts you and I one step closer to being one of the “first movers” I mentioned earlier.  It’s as if you own a home improvement store in your city, you’ve just watched Home Depot close its doors, and Lowe’s has announced a going-out-of-business sale.  Fewer investors identifying mispriced stocks leaves more money on the table for savvy active investors.

It’s a fantastic time to manage your own investments!