“Just buy something for less than it’s worth.” - Warren Buffett in an address to the faculty of Notre Dame, 1991.
One of the more widely used terms in investment is the phrase ‘mutual fund’. Sadly, most collective investment schemes are anything but mutual. Mutuality implies a shared relationship between two parties. That is not how most funds work. The typical fund management company is a for-profit business, and the end investor simply a paying client. Although most funds market themselves as ‘mutual’, almost all of them have a specific focus on gathering fee-generative assets at odds with your requirement that they concentrate on maximising investment returns. This is not necessarily a bad thing. It does not mean that all active funds give their investors a bad deal. But it’s worth bearing in mind that the number of active funds is far higher than it should be – because running them is, or at least has been, a very profitable business.
Financial language is often opaque, but in the context of collective funds it matters a lot. The term ‘mutual’ is inappropriate to describe mutual funds because these businesses are not owned by their investors. The businesses and profits are owned by the fund managers themselves. So-called ‘mutual funds’ are for-profit entities. Their investors are simply unit-holders in those funds. The end investors have no claim on the profits associated with the provision of active asset management, only on their share of the pooled assets within the funds.
The 1920s through to the 1970s amounted to a golden age for ‘mutual’ fund managers. Fortunes were made – by industry professionals, less so by the unitholders of their funds – simply by catering to the seemingly insatiable demand of retail investors for active management. Bull and bear markets came and went, but the providers of collective investment funds made out like bandits.
By 1975, however, the bloom had started to come off the rose. That year Charles Ellis, the founder of Greenwich Associates, wrote an essay that would become almost legendary in financial market circles: The loser’s game. Based on Simon Ramo’s previous study of tennis players, The loser’s game pointed out that even professional investors now had a problem. In tennis, the professional players won their games, by means of stunning backhands, for example, or on the back of amazing volleys after incredible rallies. Amateur tennis players, on the other hand, lost their games, through making unforced errors – like simply failing to get the ball back over the net. What Ellis revealed was that by the 1970s, even the professional investors were starting to lose their games. They weren’t beating the market. The market was beating them. More to the point, the professionals had effectively become the market. Given the crowded nature of the institutional fund marketplace and the impact of management fees on end investor returns, this tipping point in performance was a mathematical inevitability.
Not a bugle, but a Bogle
At the same time as Charles Ellis was drawing attention to the fund management Emperor’s new clothes, a gentleman by the name of Jack Bogle was starting a new asset management business along similarly contrarian lines. Bogle had originally been a passionate marketer and advocate for active fund management, but the collapse of the “Go-Go” years in the early 1970s pretty much destroyed his prospects. In 1975 he launched a new company which pursued an entirely passive approach to financial market investing. The name of this new business was The Vanguard Group.
Bogle and Vanguard didn’t have it easy at first. They spent years in the wilderness. The first Vanguard index fund was launched with very little hoopla in August 1976 with pitifully modest assets. The very origins of Vanguard were actually a happy accident. As Bogle himself puts it,
“When I was 38, I became head of Wellington Management, and I did an extremely unwise merger. I got wrapped up in the excitement of the Go-Go era, and the Go-Go era ended. As a result of that stupid decision, I got fired. The great thing about that mistake, which was shameful and inexcusable and a reflection of immaturity and confidence beyond what the facts justified, was that I learned a lot. And if I had not been fired then, there would not have been a Vanguard.”
Fast forward to today..
Vanguard Group, with $7 trillion of client assets and 30 million customers around the world, is now the second largest fund management business in the world, second only to Blackrock. Unlike almost all of its peers, Vanguard really is a mutual fund business. Its investors own the business, so there are no external shareholders to pay off. With no external shareholders, Vanguard can concentrate on keeping its fees highly competitive versus active fund management groups. And by focusing on largely passive investment vehicles – index-trackers run by computers rather than by human, discretionary managers – they can survive on management fees that are a fraction of those charged by the rest of the market. Having been US focused since 1975, Vanguard dropped a bomb on the UK fund management industry in May 2017, when it launched an online platform aimed directly at British investors. Shares in Hargreaves Lansdown, the largest UK online fund platform, fell by 8% on the day the news was announced. And you can see why. The Vanguard 500 Index Fund ETF, which tracks the S&P 500 stock index, has an ongoing charge of 0.07%. Aberdeen Standard’s American Focused Equity Fund, for example, carries an expense ratio of 0.94%. Vanguard threatens to do to global fund management, and its profit margins, what Amazon has already done to the retail sector. Perhaps a better analogy is that Vanguard poses as big a threat to traditional fund managers as Amazon and WalMart combined.
Jack Bogle was right to highlight the conflicts of interest that are part and parcel of many active fund management businesses. As he pointed out,
“Fund shareholders benefit from lower costs, yet management company shareholders benefit from the exact opposite – higher advisory fees, a focus on marketing over portfolio management, and the seemingly overriding goal of accumulating assets under management.”
Passive funds help address all of these problems for the end investor.
You can perhaps sense there’s a ‘But’ coming..
It’s not all good news
Vanguard’s incredible success at attracting assets has some consequences that Jack Bogle may never have anticipated.
Since 2000, passive investments globally – including index funds and ETFs – have gone from next to nothing to nearly 40% of total equity fund assets. In the US equity market, according to analysis from Bloomberg, passive funds overtook active funds by market share in around August 2018.
From the perspective of many retail investors, it might seem that active managers have overcharged and underdelivered for years, and are now getting their rightful comeuppance.
We don’t really have a dog in this fight. Yes, we manage an active fund (just the one) – but the capacity for genuine Benjamin Graham-style ‘value’ equity strategies, even on a global basis, is probably only a few hundred million dollars at most, so we’re hardly competing in the same market as the likes of Vanguard and certainly not Blackrock. By the time our fund gets to $300-400 million in assets – if that ever happens – we’ll probably have to close it to new investors.
We’re not dogmatic on this point; there’s a role for both active and passive vehicles within a properly diversified portfolio. Neither active funds nor passive funds are inherently good or bad – as with all investments, their value depends on their context, and how they’re used.
The dangers of passive investing
Vanguard’s Jack Bogle attracted his own type of groupies – the so-called Bogleheads. Many advocates of passive funds are almost messianic in their zeal for the approach. Before you sign up and go drink the Kool-Aid with them, here are some things you should consider:
For any genuine value investor, this is the clincher. The best example we can think of to reinforce this point is the IPO of Snap, the parent company of Snapchat.
Snap is a social media company but don’t ask us precisely what it does because we’re not thirteen years old. What we do know is that in recent years it has contrived to lose hundreds of millions of dollars.
Snap managed to get their IPO away in 2017 at a valuation of $24 billion. Adding insult to injury, they declined to offer their shareholders voting rights. When they reported their maiden earnings as a public company in May of that year, they disclosed a $2.2 billion quarterly loss and the stock promptly fell by 20%. There are some investments for which the words caveat emptor might have been made.
We come not to bury Snapchat, merely to point out that any index-tracking fund or ETF would have been obligated to buy its parent’s stock at launch, whether its manager (assuming it had one) wanted to or not. You can describe passive funds as many things, but ‘discerning’ is definitely not one of them.
This is hardly a new phenomenon. Passive investors in 2000 were happily allocating meaningful chunks of their money to bubble stocks like Cisco, Sun and Yahoo (and also to accounting frauds like Enron and Worldcom that ended up being worth zero).
Charles Ellis of Loser’s game fame revisited his original thesis in January 2017 in an article for the Financial Times, soberly titled The end of active investing ? In it, he stated that
“As indexing earns higher returns at lower cost and with less risk and less uncertainty, the world of active management will be taken down, firm by firm, from its once dominant position.”
Ellis doesn’t explain what he means by risk here, but since he states that passive investing is less risky, we have to assume that he means ‘tracking error’: how closely a fund tracks the performance of the index against which it’s benchmarked. As far as Charles Ellis is concerned, buying the market today is a low risk investment provided you do it through an ETF or tracker fund.
This is, of course, nonsense.
Passive investing refuses to believe in the existence of things like bubbles. And if it does acknowledge them, it isn’t bothered by them. Passive investing blithely follows bubbles all the way up and, worse still, all the way back down again. At a global level, Japan’s 1980s experience would be hard to beat. The Japanese stock market accounted for 17% of the MSCI World Index in 1982. It would go on to account for 41% of the same index in 1989, before falling back to 12% in 1997. Anybody who owned Japan in the form of a cheap index tracker would have suffered a 78% loss from its peak.
Which leads us to the third danger in passive investing:
Over two hundred years, Anglo-Saxon stock markets have generated average annualised real returns of 6% to 7%. How likely are they to achieve those returns today ?
GMO seven year asset class forecasts
(Source: GMO, as at March 31, 2022)
Fund management group GMO have a good track record of forecasting asset class returns on the basis of prevailing valuations. As things stand, over the next 7 years, they expect investors in US large cap stocks and US small cap stocks to lose money, in real terms, on the basis of current values in the stock market. Only in emerging markets (and especially in emerging ‘value’) do they see the potential for meaningful real returns over the next 7 years given today’s prices.
For pension schemes, suffice to say that requiring a 7% return but locking in a real return closer to minus 4% or minus 5% does not look like a productive way of managing scheme assets.
Low cost, not low risk
A reader of the Financial Times and its FT Money section recently wrote in with a question:
“I am looking for suitable funds to invest in.. Is there a league table for the total charges levied on all the leading general managed funds ?”
If there is, the reader in question would be well advised not to use it – at least, not in isolation.
In his recent flow of funds analysis, Ed Yardeni asks whether
“We may be witnessing the beginning of an ETF-led melt-up, which may simply reflect individual investors pouring money into passive stock index funds. Lots of them seem to be more interested in seeking low-cost funds rather than cheap stocks. In this case, valuation multiples would lead the melt-up, until something happens to scare investors out of those passive funds, which could trigger either a correction or a nasty meltdown. It is obviously a bit late in the game to start only now to be a long-term investor given that stocks aren’t cheap no matter how valuation is sliced and diced.”
Passive isn’t passive
Perhaps the single biggest problem with passive management is that, for many of its followers, it isn’t really passive at all. The average turnover rate of exchange traded funds held by investors is 880% per year. And those figures are from Jack Bogle himself. To put it another way, average “passive” investors hold their ETFs for just 47 days, on average. We’ve owned milk for longer than that. The average holding period for the SPY index fund, an S&P 500 tracker, is roughly 12 days – equivalent to an annual turnover rate of around 3,000%.
As the managers at Giverny Capital have pointed out,
“High turnover leads to lower returns (the second principle of thermodynamics applied to the stock market). For example, the SPY index fund has achieved an annual return of 6.9% over the last decade. Yet the holders of this fund, as a whole, only achieved an annual return
of 3.5%. Half of the return has literally “evaporated” into transactional activities.. there are now more than 6,000 different ETFs compared to 1,000 a decade ago. The large amount of choice and ease of transaction inherent to ETFs make their owners even more irrational.
“In short, whether it is “robots” or passive funds, the problem is not the financial product but rather the self-destructive behaviour of investors. By their impatience and willy-nilly behaviour, investors are often paradoxically the cause of their own underperformance.”
Perhaps perversely, owners of actively managed funds tend to trade their funds less actively relative to the owners of ETFs – they acknowledge the impact of higher fees on performance, and in many cases they’ve paid up-front fees that cannot be recouped once they sell. So although their route into collective funds has been more expensive on the way in, they’re not minded to overtrade.
The debate between active and passive isn’t really a debate at all. Both types of funds have their merits. Good active managers are worth their weight in gold. Ask the shareholders of Berkshire Hathaway (or Loews Corp, Fairfax Financial, or Seaboard, for that matter). But low cost trackers have a role to play, too – especially in specific niches like, say, parts of the commodities complex, or in certain stock sectors where obtaining a high level of diversification would otherwise be beyond the resources of the average private investor. But the blanket conclusion that low cost equates to superior return is not a given – especially when the markets are as overvalued as we suspect they are today. That’s when a focus on defensive value and unconstrained investing internationally comes to the fore.
As active value investors we are driven by one fact above all: the market is not entirely efficient, and on occasions is barely efficient at all. The irony is that as more and more people pile into ETFs and low cost passives, they make the market even less efficient, given that they are buying all of the components of the market on a completely price-insensitive basis. Given that ETF buyers are effectively creating huge opportunities for the rest of us, and because we can be more discerning about what we choose to buy, we should really be grateful to them.
The active fund management sector gets a bad rap because size tends to inversely correlate with value-add to end investors. As assets under management swell, returns typically lag. The larger funds invariably underperform versus smaller, nimbler rivals. But the temptation to get fat on fund fees is too powerful a temptation for most fund managers to overcome. For this reason, when engaging with third party specialists, we only invest with small, boutique managers – and these kind of managers don’t typically advertise. Some of the time, we come across hugely attractive funds that we’d love to invest in – but they’ve already closed to new investors, and they were invariably right to do so.
The passive fund sector, meanwhile, is currently sucking in assets like there’s no tomorrow. Investors will come to regret their lack of discernment as and when the markets finally and conclusively turn. Just as with active funds, passive trackers and ETFs have a role to play – primarily in those markets that are most efficient. All things equal, that means large cap, liquid markets like those reflected by the companies in the S&P 500 or the FTSE 100 or the Topix. ETFs also have a role to play in specific sectors, such as the commodities sector and gold. But in areas where markets are less efficient – smaller cap stocks or the entire world of what we’d describe as ‘specialist value’ – ETFs by definition can’t address these market opportunities well.
If you’re unsure as to whether an ETF is worth holding, ask yourself:
If the answer to any of those questions is ‘No’, you can probably find an active fund that offers a realistic alternative (what always matters most is the return after fees) – or the sector in question may just be too expensive at present to warrant any kind of exposure at all.
The great insight of the so-called Austrian or classical economic school is that value is subjective. The best Austrian managers we know have taught us that value is also inextricably entwined with that which is independent, scarce and permanent. We happen to think that those investment characteristics are most likely to be associated with niche, boutique active managers (who are either closed to new investors or en route to closing, to focus purely on performance) – but low cost ETFs can help, not least in bringing the overall fee burden down on a fully diversified portfolio. ETFs are especially suitable when markets are cheap – but good luck finding those markets today, outside the listed opportunities we are finding daily in companies operating in the real asset space. In any event, at a perhaps uniquely challenging time in the investment world, it makes sense to go into battle with the widest array of weapons you can find.
As you may know, we also manage bespoke investment portfolios for private clients internationally. We would be delighted to help you too. Because of the current heightened market volatility we are offering a completely free financial review, with no strings attached, to see if our value-oriented approach might benefit your portfolio -with no obligation at all:
Tim Price is co-manager of the VT Price Value Portfolio and author of ‘Investing through the Looking Glass: a rational guide to irrational financial markets’. You can access a full archive of these weekly investment commentaries here. You can listen to our regular ‘State of the Markets’ podcasts, with Paul Rodriguez of ThinkTrading.com, here. Email us: email@example.com.
Price Value Partners manage investment portfolios for private clients. We also manage the VT Price Value Portfolio, an unconstrained global fund investing in Benjamin Graham-style value stocks and specialist managed funds.
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