We live in the Age of the ETF. As the Financial Times has been laying out over the past week, stock market trading is increasingly dominated by exchange traded funds, which did not even exist a quarter of a century ago.
ETFs are a good idea. They are index funds, which passively track an index. Costs for those who have a brokerage account are low, and they allow easy switching between asset classes, sectors and investment styles — all of which drive the investment returns we receive.
The question, as with many good financial ideas, is whether the ETF can be taken too far, and whether it will change the nature of markets. ETFs are part of a revolution that has seen money pour out of traditional actively managed mutual funds, which try to beat the market, and into passive indexing.
Logically, this cannot go on forever. If all money is indexed, then nobody will attempt to see when capital is under- or overpriced and capital markets will cease to function. Equally logically, at some time well before passive investing takes over completely, the anomalies and distortions passive funds cause will create bargains that active managers can exploit. The hope of the moment is that the turmoil caused by Donald Trump’s election will create a “stockpickers’ market” where active managers prove themselves.
As I showed earlier this week, on a short-term basis, this is a sensible hope. The US election drove the dispersion of US stock returns (the amount they differ from each other) as high as it has been since the financial crisis in 2009, according to Standard & Poor’s. The wider the dispersion, the better the chance that a few well chosen winners will allow active funds to beat the index.
But we are just emerging from a “stockpickers’ market” in which stockpickers performed terribly. The S&P 500 made an all-time high in May 2015, and did not make another until July 2016. If you held an S&P 500 tracker you would have made nothing for 14 months (apart from dividends).
During this time, 109 companies rose more than 20 per cent, while another 96 lost more than 20 per cent. If that was not a stockpickers’ market, what was?
Something else, apparently. The purest expression of “stockpicking” is the “market-neutral” style, in which each position in a stock is paired with a bet against a similar stock. A fund might make a “long” bet on Ford and a “short” bet on General Motors, and will not care about the overall direction of the market. Providing Ford fares better than General Motors, they will make money.
Over the 14 months that the S&P was flat, the HFRX market-neutral index, tracking funds that used this strategy, gained 0.57 per cent. Not much of a return for stockpickers there. The “equity hedge” index, including funds that made sectoral bets, lost 9.1 per cent. Even now, with stock returns scattering after Mr Trump’s victory, the evidence is that a majority of actively managed funds are not beating the index.
This is not down to short-term market cycles. It is a long-term problem. Charley Ellis, who started as an active fund manager in the 1960s and found fame publishing Winning the Loser’s Game in the 1970s, a classic early text advocating index investing, has recently published a new short tome — The Index Revolution — that suggests that active managers have, over the last half century, deprived themselves of a living.
As money leaves active funds, only the best active managers are left. To come out on top, you must choose better stocks than your best rivals, he points out. And the job of investing has been institutionalised. Fifty years ago, some 90 per cent of stocks on the New York Stock Exchange were held by individuals trading on their own account. As he put it, most “bought or sold stocks once every year or two” and were advised by a stockbroker “who may or may not have read a two-page, backward-looking non-analytical tear sheet” on the company provided by Standard & Poor’s. Now, almost all money is being managed by other professional investors.
Brokers’ research departments, Mr Ellis says, usually had fewer than 10 people, calculations were carried out on slide rules, block trades were felt too risky, and if there were any computers in the office they were large bulky things in the back office — certainly not for the use of anyone trading stocks.
In such an environment, mispricings and anomalies abounded, and it was reasonable to hope that you could be the one to find and profit from them. Now, not so much. Even if there are more opportunities for active managers in the next few months, the trend is clear.
The answer is not to do away with passive investing, although there are plenty of issues with the heavy trading of ETFs. Rather, we must find a new way to allocate capital to companies, That may involve reinventing traditional active management, or build on the job now done by private equity. But in the age of the ETF, stockpickers will have to behave very differently.