Weekend Reading #34
This is the thirty-fourth weekly edition of our newsletter, Weekend Reading, sent out on Saturday 14th September 2019. To receive a copy each week directly into your inbox, sign up here.
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The cult of passive investing and the case for downside protection.
Exchange-traded funds, better known by their acronym ‘ETFs’, are all the rage. They have been for the past decade or so, as a result of the apparent realisation that passive investing is the way to go. Everyone from Warren Buffett, to your friendly neighbourhood IFA, to advertisements on public transport seem to preach the mantra of ‘pay less, get more’.
In other words, ‘Why pay for an active manager when all they do is charge fees and still underperform the market? Just buy a simple index tracker and enjoy all the benefits of a rising market without the fluff.’
The benefits of ETFs are indisputable: for one, they are cheap, with ongoing fees sitting on average at below 50bps per annum, with some even paying investors to get assets through the door. Moreover, tracking error is minimal, since algorithms (rather than fallible humans) execute on the pre-defined strategy – cold, mechanistic and unfeeling. What you see is what you get.
We’re not anti-ETF. In fact, we often make use of ETFs in our processes, in both long and short positions. ETFs are simple, straightforward instruments that offer exposure to pre-defined baskets: banks, miners, stocks in a particular country etc. Most of the time, they are liquid and easy to trade, and for an investor that wants pure beta exposure to a specific basket of stocks with no intervention other than the odd rebalance, they are an ideal instrument.
In fact, most of the time, we’d be the first to encourage investors to buy an ETF if perfect correlation is desired – they work if you’re looking for an instrument that goes up and down as much as the index does and matches it closely.
Most of the time.
ETFs are the most cost-efficient means to an end. And that end is ‘Passive investing’.
A lesson on things going wrong.
We expect that for the average investor, passive investing has been simple and straightforward, with the experience working as per the textbook definition of a tracker fund – the ETF tracks the benchmark. In the case of the world’s best performing major stock market over the past decade, this is well and truly the case:
Here we see the S&P 500 index (in black) and the SPDR S&P 500 ETF (SPY US) in orange over the past 5 years. Without too much analysis, we see the textbook outcome – SPX index performance over the past 5 years was +50.02%, and the ETF produced +49.68% in performance.
No doubt that long SPY was a winning trade, especially without big fees.
Yet, the US stock market is arguably singular in its size, depth and scale. Based on Bloomberg ETF data, out of US$3.9tn of total ETF assets as of June 2019, more than 62.6% were allocated to North America. Of these, the largest is none other than SPY US, with just north of $271bn of total assets as of this week.
Source: Bloomberg
The importance of liquidity cannot be sufficiently underscored. Liquidity is what allows the tracker to do its job. In a liquid market, units of the ETF can be created and redeemed easily without significant market impact. Furthermore, high liquidity ensures that spreads and transaction costs are low, significantly lowering the drag on performance (always to the downside) that the ETF’s trading activity causes.
Most of the time, then, things work as planned, especially when the ETF tracks the most liquid market in the world. The problems come when we attempt to track something way less liquid. In our case, some time back, it was attempting to gain long-term exposure to Pakistan via the Global X MSCI Pakistan ETF (PAK US).
Global X, as an aside, is a proper ETF operator. With more than US$11bn of assets under management, they’re one of the world’s top ETF operators and hence this is not an affront to them. The point we want to make here is that when the idealised conditions laid out in finance textbooks don’t play out, you get a very different outcome.
Over the same time period, where owning the SPY US ETF gave a near-perfect track of the S&P 500 index, owning the PAK US ETF didn’t produce the tracking effects on the Karachi Stock Exchange that we had envisioned:
Granted the index itself didn’t have a great run, clocking in at about 0% over 5 years. The ETF, however, clocked in over -60% in asset decreases. Net of a c. -40% FX depreciation vs the USD over that period, investors still end up -20% when they would’ve expected to be flat. Why? When liquidity drained from the market, the ETF itself was partially responsible for the same drain in liquidity that it had to track. Confused? Blame it on reverse correlation and reverse causality.
Of course, it’s unlikely that a shortage of liquidity would befall US stock markets, but the cautionary tale of the PAK US ETF should be heeded. In the best of times, an ETF moves up just about as much as its benchmark, owing to some minuscule trading and friction costs (much like SPY vs S&P 500), but in times of stress, not only do they also move down in tandem their benchmark, the drain on liquidity and indiscriminate selling by their underlying mechanisms exacerbates the move. This was the case with PAK US vs the KSE 100 index.
The above example is a microcosm. If we expand the same thought process to the high-yield credit space for just a single example (there are lots of others), we begin to question whether the issue of systemic risk is relevant. It’s a case of stairs on the way up and elevator on the way down – everyone queues outside the elevator at the same time, but only a few can fit. We leave this debate for another time, but it's a critical question and the truth is that nobody knows what will happen.
It's all good. Until it's not.
More poignant than the risk of liquidity drying out is the very nature of an ETF. Just as it tracks its benchmark upwards, it also tracks its benchmark downwards.
The past 10 years have led to many investors becoming enamoured by the allure of low fees and outperformance of passively vs actively managed assets, to the point of forgetting that ETFs track down moves too. The ETF does not attempt to defend its NAV in a down cycle. It simply tracks.
Almost 10 years into one of the biggest uninterrupted bull markets in the history of stocks, one cannot help but wonder if we’ve all forgotten that markets can go down too. Unless the mechanics of markets have been so profoundly altered (and perhaps there are forces in power who wish that to be true), the bull run must come to an end at some point.
Where the market has forsaken downside protection in favour of cheaper fees and the absence of active management, it leaves itself unprotected against the downside. It’s a bit like calling your insurance agent while hurtling down the Autobahn at 300 km/h to cancel an insurance policy, having been speeding for days without any incidents.
And when that fateful day comes, even the deepest, most liquid market in the world is not immune to a selloff. At that point, the passive investor will have to decide, ‘Am I willing to take whatever the market gives me in its entirety, for better or for worse, for richer or for poorer?’
Should the answer be ‘no', there is only one option, and that is to sell. Given the buy/hold vs sell decision is effectively a prisoners’ dilemma problem, any sensible observer would conclude that the outcome would be a stampede. Better to be the first one out than be left holding the ticking time bomb.
It ain't fair.
Over the past week, we’ve seen ever-louder calls from the ETF bears in the investing community branding the ETF rally a ‘bubble’. We’d like to think that this is much less a ‘bubble’ in ETFs themselves, since in reality, NAVs of ETFs have NOT diverged significantly from the underlying value of the benchmarks they track, hence there is no bubble per se. Benchmarks are a different matter, as we touched upon when we asked ‘Where did all the money go?’
In contrast, the zealous faith in passive investing (and ETFs as their instrument of choice) as the solution to all of investing’s ills almost characterises a cult – the cult of passive investing. As we pointed out earlier, ‘passive’ isn’t a natural state of affairs – somewhat ironically, it’s an active choice made by investors. And contrary to the dictionary definition of ‘passive’, this choice has material consequences, the biggest of which is the distortion of the market’s pricing mechanism.
How so, one asks, when these instruments are ‘passive’? To which the answer is ‘they’re not really.’
And the beat goes on.
Passive instruments mirror the composition of their benchmark as of the time of inception, making frequent adjustments to rebalance their contents to constantly keep up with any changes in their underlying benchmarks. Sounds good in theory, except that most benchmarks are now market-cap weighted. This means the bigger a stock’s market cap, the larger its weighting in the index. It also follows that the more buying demand there is for a stock, the stronger the upward pricing pressure, and the larger the market cap tends to be.
Put this all together and we have an interesting set up. The bigger a stock starts out in a benchmark, the more likely it is to stay bigger and get bigger, as incremental inflows into the tracker ETFs buy the largest amounts of the largest stocks, leading to these same stocks becoming even larger, drawing in new capital, leading to them becoming bigger, drawing in new capital… And the beat goes on.
The underlying assumption here is that the market is rising, and more investors, smitten by the low cost nature of ETFs, turn to these instruments to buy their market exposure. As a result, the big get bigger, and the small, especially those not fortunate enough to be in headline index benchmarks, whether the S&P 500, the Hang Seng Index, the Jakarta Composite Index or the Bovespa Index, get smaller. Many owners and managers of smaller listed companies will know the frustration of seeing the discounts applied to their companies expand, despite their companies continuing to execute and grow with their strategies.
The reason: the rise of passive investing, and the concurrent demise of many active managers, has removed the ability of the market to seek out and discover new, up-and-coming companies that have potential. The index is backward-looking, and doesn’t care about what could be, neither on the upside, nor the downside – and its trackers do the same.
And when markets inevitably start heading downwards, the same process applies, in reverse. Everyone sells the same instruments, leading to market cap shrinking the most for the big names, leading to more selling, more shrinkage, more selling… You get the idea.
Of course, no one notices it much in a rising market, and investors are quick to pat themselves on the back for ‘calling it right’ and going passive. This snippet from Bloomberg News, published last year, tells the story. No wonder some people say stock picking is dead:
When passive is really 'actively passive'.
One of the largest proponents of passive investing has in recent years been Warren Buffett himself, most notably as a result of his $1m bet in 2007 with Protégé Partners that an actively managed fund wouldn’t be able to beat the S&P 500 index tracker. He subsequently won and the passive investing community has gone on to continually reference the bet as evidence that passive is the holy grail of investing.
It’s ironic that another quote from the Oracle of Omaha himself could well be the undoing of the passive craze:
“Only when the tide goes out do you discover who’s been swimming naked.”
Of all the tides to have floated boats in the markets in the past century, none has been more prominent than the tides of QE, started as an emergency response to the near-collapse of the banking system in 2008, and subsequently enshrined as long-term government policy for more than a decade now.
The further irony is that Berkshire Hathaway, under the guidance of the dynamic duo of Buffett and Munger, is arguably the antithesis of ‘passive’, making its fortunes from an actively managed portfolio of investments, chosen according to the Ben Graham school of deep value investing. By no measure is that passive investing.
Hedge funds' role in the mix and the case for downside protection.
The traditional role of a hedge fund is to earn an ABSOLUTE return. The expectation from investors in most years is that they will receive a positive absolute return (how much depends on the risk profile of the individual fund) and they understand that they’re sacrificing upside compared to the market in good times in exchange for downside protection in the bad times.
Once upon a time, the original selling point of hedge funds was that they were uncorrelated to markets. We’re not sure that in this day and age it’s even possible to have a truly uncorrelated product to markets, but we certainly think it’s possible to have a LOW correlation product.
In our view, after a rampant decade-long bull market (in US markets anyway) and a multipolar world where the risks are increasingly disparate and unpredictable, we believe a proper hedge fund is an excellent place to deploy capital. That’s why we are not putting our own money into long only products or ETFs, but rather into our own fund, once launched.
So here’s the reality, which as always, is more complicated and nuanced than the financial press would have us believe.
Passive is not quite the holy grail that it has appeared to be, nor ‘safe’ as the 10 year recent history would suggest to unseasoned investors. If you are worried about downside it’s not only delusional to keep your money in ETFs, it’s irresponsible. In life, you get what you pay for. In this case, it’s all the upside (as evidenced more recently) but also all the downside. If you want to be protected from the downside and capture a portion of the upside, then a proper hedge fund is for you.
It is only because underlying benchmarks have been on a climb for the past decade that passive investing has delivered ‘absolute’ performance for so long. We don’t know when that climb will end, but we do know that nothing lasts forever.
Ultimately, as long as we keep our eyes on what could go wrong, and plan meticulously for that scenario, the upside will take care of itself.
What we're doing.
We have been very busy as our business has ratcheted up a notch.
The most exciting news of the week is we made our first hire at Three Body Capital. As we approach the launch of our fund, brokerage and deal platform for professional investors, it’s essential that we build and maintain a robust operational infrastructure. With this in mind, we’re excited to announce that operations guru (and old friend) David Kemp has joined us to lead our operations, risk management, monitoring and compliance activities.
We’re hugely excited to have David on board and looking forward to giving him a proper TBC welcome over lunch at one of Camden’s finest budget eateries – when he’s had time to look up from his desk!
We’re also motoring along with product development for 3BC, our deal platform for professional investors. The “alpha” version of the product (so-called because it precedes the beta version, not just because we love alpha!) is close to being signed off by our developers, and we look forward to getting this into the hands of our friends and investors so we can begin refining the user experience. If you’re a professional investor who loves technology, private markets and being ahead of the curve when it comes to sourcing unusual opportunities, then we’d love to include you in our test phase and get your feedback on how we can improve the platform. Hit us up if you’re interested.
We recently attended PKO BP’s gaming conference in London and met a number of companies large and small, from our storytelling favourites CD Projekt to smaller freemium model players like Ten Square Games. We have written before about the plethora of talent in Polish gaming and we left the event full of continued enthusiasm for the development of this sector.
Finally, we went to our first blockchain event, DeFi Summit, held on campus at London’s Imperial College. DeFi stands for decentralised finance and the blockchain’s community’s blooming mission to innovate financial products. The spectrum is enormous, ranging from solving for financial inclusion in poor countries to invoice factoring in some of the world’s wealthiest places. It was an eye-opening experience and an excellent furtherance of our education in this space. There were hundreds of developers, academics and investors and the event followed a lecture format. At this stage, the community is limited to mainly academics and developers and some very early investors. There has yet to be a killer product as it is SO early. But in our view, the rate of innovation is staggering and we continue to monitor and learn so we are ready for when this space goes mainstream.
What we're reading.
We don’t spend a lot of time reading academic papers on the science of investment management – we prefer to look for insights elsewhere, in the real world, building a mosaic of actionable information from a host of weird and (sometimes) wonderful sources.
But this week we stumbled across a substantial and thought-provoking paper entitled 'Explaining the Demise of Value Investing', authored by Baruch Lev at New York University and Anup Srivastava at the University of Calgary.
The demise of value investing since the Global Financial Crisis has been well documented, but the reasons behind this trend have eluded investors and academics, until now. This paper uses extensive data analysis to show that value has, in fact, been unprofitable for almost 30 years, barring a brief resurrection following the Dotcom debacle. It identifies two major reasons for the demise of value:
1/ Accounting deficiencies causing systematic misidentification of value;
2/ Fundamental economic developments that significantly hampered the reshuffling of value and growth stocks.
The paper concludes that the likelihood of the resurgence of value investing seems low, which we tend to agree with, considering how markets have fundamentally changed in recent years.
But the thing we really love about this paper is the epithet it uses to describe growth stocks. 'Glamour investing' isn’t a phrase we’ll be using to pitch for AUM, but it’s certainly memorable!
What we're listening to.
When it comes to podcasts, Recode Decode is a favourite of ours.
In this episode, Jennifer Eberhardt, professor of psychology at Stanford University, explains how hidden biases shape our lives, combining great storytelling with an intensive look at the science of implicit bias. Dr. Eberhardt draws on reams of empirical research to challenge the idea of human objectivity, with a focus on racial bias among police officers.
Here at Three Body Capital we believe that deeply entrenched personal ideology (either conscious or implicit) can and does hamper effective investment management, and we're committed to identifying cognitive biases and eliminating them from our investment process.
This is central to our approach to generating returns for investors, and we're looking forward to formalising our approach in an upcoming newsletter. For the time being, this podcast is required listening and provides a great intro to a subject we care passionately about.