“And can you do Addition?” the White Queen asked. “What’s one and one and one and one and one and one and one and one and one and one?”
“I don’t know,” said Alice. “I lost count.”
Investors are being lured down the rabbit hole of lower costs.
Replacing managers in portfolios by low-cost exchange-traded funds (ETFs) one and one and one...
Lowering costs at first glance seems a no-brainer. Less drag on returns must surely be commendable.
But in this article, I urge you to go through the looking glass, and question what are you ADDING to your portfolio when you do that?
Successful investors look deeper at second- and third-order effects. How will buying overcrowded and expensive assets work out for you five to 10 years from now?
Does the maths of DIVIDING low-cost investors from active approaches, corralling them into a valuation-insensitive herd, when margin debt is at unprecedented highs, and asset-liquidity risk and index concentration is increasing, make sense?
Investors are responding to financial repression by trying to lower costs in a low-interest environment.
But in this Wonderland of wishful thinking, now is the time for caution.
“She can’t do Subtraction,” said the White Queen. “Can you do Division? Divide a loaf by a knife – what’s the answer to that?”
We have witnessed an international stampede of capital into ETFs into an overheated market.
The flows have been relentless with global ETFs slicing another $633bn in 2017 from actively managed assets, up 67% from the year before.
But has it been the right time to buy? US market valuations are very stretched irrespectively of the metric you choose.
For example, the S&P 500 price-to-sales ratio at the end of February 2018 was 2.2, close to highs last seen in the dot-com 2000s.
Market commentators, like GMO and Hussman, caution prospective returns for general equity from these heady levels could be negative over the next decade.
Yet Blackrock’s ETF study shows a $196bn flood of flows into US ETFs in 2017. I urge investors to resist the siren calls of cost, and ask “when” and not just “what” to buy.
Buying high and selling low is not a recipe for investment success.
The market now has a greater proportion of investing money lying with uninformed investors. Many of these passive funds have no discretion to build cash buffers.
Every net redemption is a sale. Every sale ignores price. Post-2008, there is significantly less prop-desk activity and appetite to provide shock-absorbing liquidity in times of crisis and uncertainty.
(Prop-desk activity refers to proprietary trading, when large financial institutions use its own capital to conduct financial transactions, e.g. trade shares.
These trades are often speculative in nature, according to Investopedia.) Adding to this precariousness, investors are highly leveraged with margin debt at never before seen highs.
The massive shift to price-insensitive investing means more investor portfolios are unwittingly exposed to the unintended risks of an asset liquidity spiral, where forced selling drives down asset prices.
Markus Brunnermeier and Lars Pedersen outline these mechanics where a downward spiralling pattern of losses impacts trading capital, leading to tighter risk management – further pressurising asset sales, creating a destructive cycle of drying up of liquidity feeding lower asset prices.
However, low-cost managers are valuation agnostic and have no asset management discretion to protect investment values in a crisis.
Bear markets will truly divide active and passive investors, and the lure of initial cost savings versus actual returns will cut like a knife.
“...but the Red Queen answered for her. “Bread-and-butter, of course.”
The bread and butter of low-cost investing are broad market indices, which are generally market-capitalisation weighted.
In times of market exuberance, excessive price momentum (as witnessed by the FANG stocks – Facebook, Apple, Netflix and Google’s parent company Alphabet) and excessive capital issuance can distort valuations and dilute index investors.
As an active equity investor, I would rather focus my capital on undervalued counters and reward company management who protect shareholder interests.
Second-order effects are more sinister in the bond indices, where market-cap weightings mean investor capital is being channelled into issuers who are more and more indebted.
The Bank of International Settlements (BIS) recently cautioned that passive investors are “weakening market discipline”.
Closer to home, highly concentrated indices can force low-cost investors into making unintended outsized stock bets.
Naspers* dominates South African indices with around 17% of the FTSE/JSE All Share Index (Alsi) and 21% of the JSE’s Shareholder Weighted Index (Swix), yet their prudential legislation Regulation 28 has a maximum limit of 15% in stock.
In international markets, Apple is the counter that dominates US indices, and is an outsized holding in popular tech, growth and value sub-indices. So low-cost investors’ expectations of a well-diversified low risk “bread-and-butter” portfolio might find they have a bit more spice than expected!
“…Try another Subtraction sum. Take a bone from a dog: what remains?”
I fear it is not just retail investors that are getting sucked down the road to potential “worsification”.
As the market melts up, Harvard University, in a desperate attempt to play catch up with peers, is proposing switching to a S&P 500 ETF for half of its assets.
This is less looking glass, and more rear-view mirror – fighting over a bone from yesteryear’s war.
“Wrong, as usual,” said the Red Queen: “the dog’s temper would remain.”
The burden of saving is increasingly being placed on the shoulders of individuals, with defined contribution arrangements, less employer engagement, and state benefits (and past promises) being cut back.
And with the next generation of savers being burdened with student debt, and at times underemployed, their capital could be viewed as even more sacred.
I believe that low-cost investing certainly has a place in one’s portfolio as an effective modest core, enabling a complement of more diverse, truly active investments. However, investors should be “buying the index” when it is cheap, and with regard to market structure.
When the dust settles at the end of the next bear market, the unintended consequences of this headlong rush into low-cost (price-insensitive, valuation-unaware) investing will be revealed.
We face the potential of crippling sequence risk for an investing generation who bought cheap but suffered the worst case of market timing ever seen.
In an environment of growing populism and well-coordinated social media activism, it won’t just be a dog’s temper but a pack of wolves’ fury that will remain.
SOME PRACTICAL THOUGHTS FOR PORTFOLIOS
- Separate fad from fiction
ETFs shooting the lights out will get lots of media attention, but that does not make them the right investment for you.
These funds may hide complex risks. The inverse VIX trade (XIV) made money for years until it lost a crippling 90% (after hours) and soon closed!
- Drink Me, Eat Me
Just as Alice had to “right-size” herself with growth and shrinking potions, investors need to restructure their portfolio with the right blend of both valuation and cost.
This might mean phasing in low-cost strategies across a business cycle. Avoid going all in.
Dr Michael Streatfield, a chartered financial analyst (CFA), is founding partner and chief scientist of the global hedge fund advisory Fortitudine Vincimus Capital. He writes in his personal capacity.
Quotes in bold italics from Alice Through the Looking-Glass by Lewis Carroll (1872).
*finweek is a publication of Media24, a subsidiary of Naspers.
This article is part of our April 2018 Collective Insight supplement, which appeared in the 26 April edition of finweek. To download the entire supplement, click here. Buy and download the magazine here. Subscribe to our weekly newsletter here.