The wealth management and institutional consulting communities
have allowed indexing to be called "passive" investing and
stock-picking disciplines to be called "active" management. This
implies a mindless approach to indexing and a great deal of
busyness to stock picking. A number of recent articles and
commentaries have been written, which question the viability of
stock-picking disciplines in an era of numerous indexing choices
and ETF vehicles. We at Smead Capital Management believe these
labels are at the heart of a great deal of confusion about what
works and what doesn't work in both equity mutual funds and
separately managed accounts.
The latest article we've read came on January 22, 2013, from
. George Sisti, a guest writer on retirement planning, argued
adamantly against "active" management in a piece called "Forget hot
funds and market-beating managers." His thesis: since nobody can
predict the future or where the market is going each year, nobody
can beat the stock market over long stretches of time.
Why not? Something called an efficient market - think of it
as money manager gravity - which keeps even the smartest
managers from outperforming the market over the long haul. In
an efficient market, the current price of a stock is the
consensus opinion of all those smarty types' collective
judgment. If their consensus opinion is that XYZ stock is
undervalued, they will rush to buy it and its price will rise.
Conversely, if they believe that XYZ is overvalued, they will
sell it and its price will decline.
We believe it is correct to be skeptical of a majority of equity
mutual funds, but believe thinkers are wrong about long-duration
outperformance. We believe there are actually a number of very
meritorious stock-picking disciplines, which do add value for
investors and there are a number of factors that argue in favor of
effective "active" management.
FACTOR ONE - Valuation Matters Dearly
Eugene Fama and the others who came up with the efficient market
theory have written extensively about mechanical valuation-oriented
stock-picking disciplines. For example, Fama and French concluded
that the lowest price-to-book ratio (P/B) companies outperform the
market and the other categories. Even efficient market theorists
have identified ways to beat the stock indexes. Here at Smead
Capital, we found that Fama-French like academic studies by
Bauman-Conover-Miller, David Dreman and Francis Nicholson all came
to the same conclusion - VALUATION MATTERS DEARLY! Take any
valuation metric like price-to-earnings, price-to-dividend,
price-to-book, or price-to-sales and the lowest 20%-25% of the
companies outperform the index over both one- and multiple-year
holding periods. Additionally, it works with annual rebalancing and
in Nicholson's study as a static portfolio. In fact, the benefit of
buying cheaply and holding statically grows more and more each year
in his study.
FACTOR TWO - Index Strengths and Weaknesses
Most discussions don't delve into what indexes do. What the
"passive" indexes do well or what they do poorly in comparison to
actively managed equity funds is never dissected. In a piece we
wrote in March of 2010 called "
Long Duration Common Stock Investing
," we explained what we believe the indexes do well and what they
do poorly. Index expenses are low, turnover is low, trading costs
are minimal, winners are held indefinitely, and market-cap
weighting causes winning stocks to be magnified.
In our opinion, there are a few things the indexes do poorly.
First, an index has no way to get away from poor-performing
companies like General Motors in 2008 or Kodak during the last
decade; they are usually forced to ride them to zero. Additionally,
the index suffers from massive capital misallocations like the tech
bubble in the late 1990s and energy stocks in 1980. There is no way
for the index to get away from a concentration in immensely popular
industries and sectors and no way to over-allocate to undervalued
industries and sectors.
FACTOR THREE - Rearview Mirror Attitude
A majority of commentators fail to consider the market's
range-bound nature since the start of 2000 and how that has colored
advisor attitudes. Why is indexing even called "passive" and why
are stock-picking organizations called "active" managers?
Indexing is considered "passive" because of the attitude needed
by the owner not the overseer
. In the period from 1992 to 2009, the S&P 500 index had 4.63%
turnover. Companies were bought out and left the index or performed
so poorly that they were removed from the index. Standard and
Poor's then chooses a replacement from among companies which have a
certain market capitalization. In our words, the index is not
passive, it is automated and mechanical.
The mechanical nature of "passive" funds flourished since 2000
for two reasons: first, the index rides it winners to a fault and
is capitalization weighted. Big multiple-year and multiple-decade
winners are allowed to run uninterrupted; second, index funds spend
almost nothing on trading costs or bid and ask spreads. The Boston
College Center for Retirement Research concluded that large-cap
U.S. equity funds in 401(k) plans spent 1.31% annually in trading
costs on average. Compare that with .05% or less annually for
S&P 500 Index funds. It's a 100-meter dash annually for the
index, while the funds are running about 102.75 meters in the U.S.
large-cap space each year to keep up.
FACTOR FOUR - Passive Index Popularity Changes Future
The fact that the popularity of indexing has already become a
huge part of long-only U.S. large-cap equity investing hasn't been
factored into future result expectations. Therefore, it is our
opinion that significant implications exist today for finding
long-term alpha when there is less money being fed to "active"
management and fewer long-duration stock-picking disciplines being
practiced in the long-only space.
The extra distance in the dash is why they are called "active"
funds. Annual portfolio turnover in equity mutual funds has
approached 100% in recent years. We believe investors in these
funds are losing out two ways. They are throwing away returns
directly through trading costs and indirectly by cutting off their
best-performing individual stocks due to the impatience of the
manager. A few years ago, the manager of the T. Rowe Price "New
Horizons" fund, Jack LaPorte, retired. When asked why his fund had
done so well over 15 years he said, "My average hold was four
years, while the average portfolio manager [held for] about 10
months. I don't know how others can make that a successful way to
To understand how important costs are to the index advantage you
only need to compare what percentage of U.S. large-cap blend equity
funds outperformed the market over the last five- and 10-year
periods as compared with a Russell universe for U.S. large-cap
equity separately managed accounts run by many of the same
managers. In Morningstar's database, 35% of large-blend U.S. equity
funds beat the S&P 500 index over five years and 40% beat over
10 years. In Russell's universe of U.S. large-cap equity
portfolios, 60% beat the S&P over five years and 82% over 10
years. The difference in Russell's universe is it is gross of
management fees. The management fee for SMAs compares with the
expenses associated with running the funds (annual net expense
ratio), which includes both management fee and operating expenses
born by shareholders. If the Russell universe managers charged an
average of .65%, this would mean that .65% less trading cost or
operating expense in a fund theoretically doubles the number of
index-beating funds over 10 years.
The most germane quote on the attraction to indexing comes from
William Sharpe, who helped create the Capital Asset Pricing Model
((CAPM)) and the Sharpe ratio:
Should everyone index everything? The answer is
resoundingly no. In fact, if everyone indexed, capital markets
would cease to provide the relatively efficient security prices
that make indexing an attractive strategy for some investors.
All the research undertaken by active managers keeps prices
closer to values, enabling indexed investors to catch a free
ride without paying the costs. Thus there is a fragile
equilibrium in which some investors choose to index some or all
of their money, while the rest continue to search for mispriced
securities. Should you index at least some of your portfolio?
This is up to you. I only suggest that you consider the option.
In the long run this boring approach can give you more time for
more interesting activities such as music, art, literature,
sports, and so on.
We emphatically believe that what Sharpe said in 2002 does not
apply today for two reasons. The range-bound market of 2000-2011
rearranged the behavior of most stock pickers, in particular the
thinking of equity managers and people who research managers. The
difficult markets damaged the general belief in the merit of "buy
and hold" common stock investing.
In the opinion of SCM, "Active" managers - or what we like to
call "way too active" managers - seem to have massively migrated
away from stock selection that is based on long-term or
long-duration time periods. As we see it, the proliferation of
hedge funds and an urge to satisfy financial advisors and managers
has increased their activity levels, driving them to move in and
out of markets too quickly. Thus, we maintain, that the
historically-high average turnover among equity funds, scarcity of
effective long-duration analysis, and newly normal expense
levels/trading costs doom the "active" management community!
Ironically, the other thing that Sharpe couldn't have known in
2002 was the move into
and their open-armed adoption in the large-cap space of "passive"
index investing. Remember, Sharpe's attitude was based on the
efficiency of all those professionals doing effective and usually
long-term research. In the process, they were squeezing the under
and over valuation out of the market. A nearly four-year bull
market in stocks is being met by massive and continuous liquidation
of funds run by stock-picking organizations. A part of this money
is moving to ETFs dominated by indexes causing the efficiency of
the market to disappear fairly fast. You could see this in the
incredibly high correlations among stocks in the S&P 500 index
in the last three years. If the markets are efficient, how could
all stocks move simultaneously do to the "risk-on risk-off"
A TEMPLATE FOR EFFECTIVE "ACTIVE" MANAGEMENT
The ultimate irony in all this is the abdication of effective
long-duration research and "buy and hold" investing.
Huge amounts of capital have fled to indexes, which do exactly
the thing that "active" managers refuse to do
. In this odd way, we believe these circumstances have created a
wonderful opportunity to do what the index does well and improve on
what the index does poorly. Let me summarize the behaviors that are
needed to outperform the market over long time periods.
- Reasonable management fees or fund operating expenses
- Low turnover/hold winners to a fault
- A commitment to valuation
- Poor performing stocks regularly culled for possible
- Avoidance of overly popular companies, industries and
Here is what we wrote in early 2010:
Ben Inker, research director at Grantham, Mayo and Van
), exposed what is wrong with the high level of activity and
portfolio turnover at the average actively managed fund. His
work shows that 75 per cent of the current intrinsic value of a
stock comes from cash flows earned more than 11 years from now.
Why are short term business prospects receiving most of the
professional investor attention when company durational success
should be their focus?
To tie this together we will refer you to a 1984 piece Warren
Buffett wrote for the Columbia Business School magazine called "
The Superinvestors of Graham and Doddsville
." Buffett argued then that the efficient market theorists were
wrong because everyone that he had known over the prior three
decades, who practiced the disciplines we described, had soundly
beaten the S&P 500 index.
In conclusion, we believe that there are very few stock-picking
organizations that are practicing these disciplines today. To
paraphrase Buffett, hardly anyone does the discipline, but everyone
we know who does it succeeds over long-duration periods. In our
opinion, the scarcity of dedicated participants raises the alpha
available to the ones who are practicing the discipline. The
popularity of indexing and the defensive busyness of "active"
managers have created a significant reduction of competition in
stock picking. This raises profit margins (alpha) in stock picking,
as a reduction in competition does in any other industry.
Therefore, we believe that those who advise and manage wealth
should make the effort to understand this discipline and benefit
from this market dislocation. We believe stock-picking
organizations, financial advisors, and institutional investors need
to recognize these possibilities.
I have no positions in any stocks mentioned, and no plans to
initiate any positions within the next 72 hours. I wrote this
article myself, and it expresses my own opinions. I am not
receiving compensation for it. I have no business relationship with
any company whose stock is mentioned in this article.
The information contained in this missive represents SCM's
opinions, and should not be construed as personalized or
individualized investment advice. Past performance is no guarantee
of future results. It should not be assumed that investing in any
securities mentioned above will or will not be profitable. A list
of all recommendations made by Smead Capital Management within the
past twelve month period is available upon request.
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