Stocks posted another gain last quarter as measured by the two major indices (the S&P 500 and the Dow Jones Industrial Average, see Figure 1), but it really didn’t feel like a good quarter, did it? With the small stock Russell 2000 Index falling -7.4% and the MSCI World ex-US Index off -5.7%, diversified portfolios did not have much of a chance to finish in the black. See Figure 2.
The proximate cause of the overall weak stock market was the global economic slowdown. First, the economic malaise in Europe appeared to spread to Germany, leaving that region with no remaining growth engine. Mario Draghi, president of the European Central Bank, who famously started the European recovery in 2012 by saying “we will do whatever it takes” to ensure that no EC member state would default, seems to have no solution for the recent slump. This has led to a steep decline in the Euro against the dollar. Measured in Euros, European stocks lost only -24 basis points (-0.24%) last quarter, but translated to US dollars that loss ballooned to -7%. By and large, as unease about global growth spread, investors turned to the strongest and deepest world market (the U.S stock market), and bought those sectors they felt would be most immune to a cyclical slowdown (health care and technology). Energy stocks were by far the worst performers (-8.6%) as not even significant unrest in the Middle East could offset the twin negatives of falling global energy demand and rising supply out of North America.
Risk aversion also spilled over into the bond market, which rose just 0.2%. Despite all the warnings we’ve been getting about rising inflation, the best areas of the bond market to be in last quarter were interest-rate sensitive – long term municipal and government bonds. Foreign bonds had to contend with the strong dollar, which more than wiped out the interest rate-related gains (currency-hedged foreign bond funds performed well). High yield corporate bonds declined due to economic and liquidity concerns; investors grew concerned that bidders wouldn’t be there if the economy continued to slip.
The performance difference between large company stocks (up 8.3%) and small company stocks (down -4.7%) this year has been staggering. We made some good decisions at the margin. We trimmed small company stock exposure in favor of larger cap funds. We bought municipal bonds in taxable portfolios. We sold out of high yield corporate bond positions such as Ivy High Yield. That said, some of our “good” decisions did not work out as well as we would have hoped. We selected Aston Independent Value for its willingness to go to cash if valuations got too extreme (the manager had skillfully navigated through the down markets of 2008 and 2011). Unfortunately, it declined more than -4% last quarter despite having over 70% of its portfolio in cash. First Eagle Global, a global fund with a stellar down market track record, failed to lose less on the down side this time. Past performance really is no indication of future performance, unfortunately.
Last quarter we suggested that we were in a kind of best-of-all-worlds where the economy is growing enough to ensure profit growth but not strong enough to put upward pressure on interest rates, and that this allowed for modestly favorable stock and bond market performance. Recently this equilibrium was upset as world economic growth turned meaningfully lower. A weaker global economy is positive for bonds but not so for most stocks. We have been dealing with those global market dynamics since the fourth week of September. Once again the markets seem to be asking central bankers for a solution, but it appears their quivers are out of arrows. Perhaps there are limits to the power of the world’s central banks. Maybe if debt burdens are too high people simply can’t buy as much no matter how low interest rates are. Perhaps the world went on such a buying binge between 2003 and 2008 that flooding the capital markets with liquidity – as the Federal Reserve, European Central Bank, Bank of Japan, and others have done since 2009 – only delayed the inevitable. It looks like our luck might not hold after all.
That said, one good thing to come out of a weaker global economy is lower energy prices. Traditionally this helps the economy because consumers have more money left to spend after accounting for their energy needs. If we get a recovery in stocks over the next several weeks, it will likely be in the consumer discretionary sector as investors begin to bet on a stronger holiday shopping season.
Commentary – Is it the Golden Age of the Index?
I alluded earlier to two funds where we have done quite well in the past having failed to perform well during this market downturn. The list of funds meeting that description is unfortunately much greater than two. Some we owned and some we did not. The common denominator is that each of these funds has a high “active share” which is money manager speak for the degree to which the fund deviates from its benchmark. Over time, studies have shown that funds with a high active share add value. That said, they do not always and at all times add value. We have been going through a period, obviously, where they by and large have not. The question then becomes, is this approach still valid? Should portfolios be run much more like market benchmarks?
We are always asking ourselves how we can make portfolios better. Can we squeeze out more return for a given amount of volatility? Could we actually get better returns taking less risk? According to an academic theory called Modern Portfolio Theory, the answer is no (because return and volatility are positively correlated). And yet in the real world the answer has been yes. Researchers have documented what is called the Low Volatility Anomaly which shows that low volatility stocks have actually outperformed the market. Many funds have been created over the last couple of years to try to capitalize on this anomaly and have thus far done fairly well. I have to wonder, however, if we are not witnessing an over-reaction to a previous investing fad.
I remember managing money in the late 1990s. Academic literature and the success of Warren Buffett had long since established the supremacy of value investing (again, for the non-practitioner, the idea that one could earn superior returns by investing in statistically cheaper companies as measured by price-to-book-value, price-to-earnings, and/or price-to-cash flow). From 1993 through 1999, however, value investing most emphatically did not work! A portion of the underperformance during that time period could be attributed to the fact that many investors got caught up in technology mania. That said, I suspect another part of the underperformance problem may have been that value investing’s advantage was well known and by 1993 too many people were pursuing that investment style at the expense of faster growing but more expensive industries like technology which were poised for takeoff.
The point I’m trying to make is that good ideas can be taken too far, creating (temporary) anomalies in the opposite direction. Maybe some very good fund managers allowed themselves to venture too far from the benchmarks on the idea that the more “active” you were the better. I just find it hard to believe that so many great fund managers have lost their “touch” at the same time. Perhaps another explanation is possible.
We are going through another golden age of the index. By this I mean a time period where the major indices are very difficult to beat. Part of the reason is obvious – with very low expenses (including miniscule trading fees), they have a built-in advantage. That said, are markets really so efficient that no active manager can hope to outperform them over the long term? Increasingly index proponents are saying so. I just have a hard time believing that for two primary reasons. One, I know that almost all indexes are capitalization-weighted, which means that the more a component of the index (Apple, for instance) goes up in price the more of it the index has to own. The reverse is true with falling stocks. Therefore, at the margin every day the index buys high and sells low. That just cannot be a successful strategy over the long term. The other reason is that active foreign managers have done well over time relative to foreign indices. This is largely the result of Japanese stock having ballooned to a huge percentage of the MSCI EAFE index by 1990 and then gradually fizzling lower ever since. Just about every active international manager was underweight Japan over the last two decades which helped them beat the EAFE. The same thing on a much smaller basis happened in the U.S. from 2000 through 2005. Microsoft and General Electric were valued at $586.2 billion and $475 billion respectively at the end of 1999. By the end of 2005 they had shed a combined $384 billion, and this contributed to the average active fund having beaten the S&P over those six years.
Since 2008 the S&P 500 looks exceptionally strong relative to the average stock fund. Much of this, I contend, is due to the superior performance of Apple, Inc., the S&P’s largest stock. Apple, with a market cap of $84.5 billion, wasn’t even in the top ten at the close of 2008. Today it’s market capitalization is north of $600 billion. The S&P 500, therefore boosted its relative Apple stake sevenfold. Any fund manager not buying Apple with both hands over the last five years was at a significant disadvantage. I’m happy for Apple (and by extension the S&P 500), but I remember how Japan worked out for the EAFE.
The point is, no approach to portfolio management, be it active or passive, value or low volatility or otherwise, gives you an advantage that can be counted on at all times. There are factors that over the long sweep of time do appear to offer a modest advantage. However, at any given time the popularity of one or more of these factors may cause mispricing to the extent the advantage is negated or even temporarily reversed. Apple will not be the most valuable company in the world forever, and when it inevitably regresses towards the mean the S&P 500 will suffer on a relative basis. Active managers whose long term track record suggests some level of skill may once again prosper. Meanwhile, we will continue to do our best to combine those managers who have historically added value with indexes in areas where efficiency and low cost offset manager expertise. Sometimes it will be obvious that this approach adds value, and other times it will seem like we should have just indexed the whole thing. That’s just how it goes.
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 Per Morningstar (Benchmark Universe)
 Per Morningstar, MSCI Europe net return in dollars (-7.00%) and in local currency (-0.24%)
 JP Morgan Guide to the Markets, Third Quarter 2014
 Per Morningstar, Barclays US Aggregate Bond index, net return in US dollars
 The large company is the S&P 500 Index; the small company proxy is the Russell 2000 Index
 Antti Petajisto, Financial Analysts Journal, Vole 69 (2013)
 Nardin Baker and Robert Haugen, Social Science Research Network (2012)
 Morgan Stanley Capital’s Europe, Asia, and Far East Index
 Wikipedia, List of public corporations by market capitalization
 Wikinvest, Apple market cap 2008