“Ignoring cycles and extrapolating trends is one of the most dangerous things an investor can do.” – Howard Marks
A controversy in the investing community which has been around for decades and is still unresolved is the active vs. passive equity investment debate. Before providing some of our own thoughts to this very intriguing topic, we wanted to share once again some of our core beliefs which remain our pillars that drive our investment process and mindset.
- First, we believe, over the long term, valuations will drive stock returns by anchoring market prices to the hard reality of cash flows. In the short-term, stock prices are driven by the market’s changes in expectations and its level of uncertainty.
- Second, the most important task of every active manager is to distinguish between a company’s fundamentals and the expectations implied by the price.
- Third, emotions and heuristics systematically cause investors to make forecasting errors and are therefore the main reasons for mispricings in the marketplace, resulting in elusive market prices which we try to take advantage of.
- Fourth, the future is not predictable and far too complex to grasp in a single number, however, investing deals with the future. Therefore, there is always uncertainty.
- Fifth, past performance is a horrible indicator for future outperformance. We focus on the long‐term and consider short‐term investment results transitory and meaningless to evaluate one’s investment process.
- Sixth, mean reversion (“cycles”) come in all shapes and forms and are the source of mispricing as they are created by humans. Fundamentals, psychology, prices and returns will rise and fall, thereby providing us, the active investors, with opportunities to make mistakes or profit from the mistakes of others.
Both camps, active and passive investing, have valid reasons for being the better choice for any individual investor, however, as a whole they need each other and one without the other will not do. Similar to a summer in Germany, you cannot have the sun and not expect some rain in the meantime. Nevertheless, one cannot survive without the other as the passive investment community alone would ignore the most important element of investing: the pricing of securities based on fundamental data.
Yet, just as any other element of investing is cyclical, so is the perception of the relevance and value-add of active management throughout different periods. At times, venture capital firms can’t raise a dime and at times of great certainty and optimism, they get flooded with investments. However, the market is rather consistent at being too optimistic or too pessimistic at the wrong time. In times of great “certainty” and comfort, low returns are likely to follow as prices are high. In times of “uncertainty” about active management, investment styles, or the market in general prices tend to be low so that the opportunity for higher future returns increases. These are times to be aggressive and take advantage of the fear of others.
A widely covered and discussed topic nowadays is the fact that over the last decade an increasing portion of the investments in stocks were directed into passive funds while active fund managers experienced constant net outflows. As a result, the share of passively managed funds in the market has been continuously increasing to new highs.
There are, of course, valid reasons for this development. The fund management industry as a whole does not score well when it comes to performance, transparency, and fees. Passive funds or closet indexers provide an effective vehicle to buy the market return inexpensively while simultaneously providing liquidity. For private, small and unsophisticated investors it could perfectly make sense to build passive portfolios focusing only on allocation of the assets and costs. Another positive effect for investors is the pressure passive funds have put on fees charged by active managers. Due to continuous and sometimes disruptive advances in technology, which led to a cost reduction in gathering information, trading and communication, high fees charged do not seem to be sustainable.
As always, there are two sides of a coin; passive investing not only shows pitfalls but also creates a changing environment for all market participants.
For value investors like us, passive index investing makes little sense as it:
- structurally overweights expensive stocks while underweighting cheap ones, and
- does not buy or sell stocks based on fundamentals/valuation but rather because they performed well in the past.
While ETFs are called “passive” index funds, they are trading very actively; recent history shows that US ETFs had a trading volume higher than the entire US GDP (20 trillion USD in 2016). Unless you believe you can actively time the market or subsets thereof, such a “strategy” is counter its original intent. Active managers like us are, due to the high share of passive investments, increasingly competing against investors following simple rules for buying and selling without regards of the fundamental value of the underlying assets.
Active investing has always attracted some of the brightest minds, but now also passive investing has been evolving towards more sophisticated alternative approaches. This brings us to so called “Smart Beta”: Such an approach, systematic and rules-based, provides exposure to factors and styles. Smart Beta products offer explicit exposure to value, quality, momentum, low volatility and size reciting just the most popular ones.
These Smart Beta products no doubt have the advantage to provide investors with the possibility to gain a certain required or wished for exposure (provided the investor really understands what hides behind these factors in terms of style and exposures). As passive products, they do constitute the desired exposure at a reasonable price. Additionally, Smart Beta products manage to remain systematic and follow the underlying rules consistently throughout the cycles even when confronted with temporary headwinds; something active investors often struggle to achieve.
However, a key element often underestimated or forgotten is the source of the alpha. Momentum, low-volatility and quality products are currently trading at high valuations compared to their own history, as a result of their great performance and inflows.
“Whenever you find yourself on the side of the majority, it is time to pause and reflect.” (Mark Twain)
For us, the starting valuation (at time of purchase) is the most reliable indicator for future returns.
As the popularity of any strategy increases (often the result of superior past performance which is usually a horrible investment guide) noticeable herding effects can be observed. Consequently, the factor gradually becomes more and more expensive, lowering the expected future returns. Also, value as a style, will be expensive or cheap throughout cycles. However, value investing should be able to navigate through the cycles in a smoother path, as there is always value to be found. We would also like to mention that all strategies, in order to be successful in the long run, are mostly reliant on value and size premium as shown in a paper by Rob D. Arnott2.
Lingohr & Partner, as one of the pioneers, has a team that can look back at almost 25 years of experience in the field of factors and multifactor models. We do not share the widespread belief that factors are becoming an investment “commodity”. There are extensive discrepancies between individual strategies claiming to offer exposure to the same factor or style (e.g. value, quality and momentum). As there is almost an unlimited number of possibilities of calculating multiples and putting factors together, systematic managers are often tempted to overfit their models focusing on output rather than input. We believe the work needs to be done prior to the actual testing in the form of creating a concept.
We, above all, put a lot of emphasis in conceptually calculating and formulating factors in order to embed them with an economic underpinning. This way, our models and factors can find solid companies at bargain prices rather than improving our backtests for specific time frames in history. History does not repeat itself in every detail and its complexity is far too great to be narrowed down by optimized models. This is the main reason for our outstanding long-term track record. Our experience gives us the confidence and strength to stick to our proven approach during short-term headwinds, as nothing works all the time - while other investors simply jump on the bandwagon chasing performance.
Active and passive investing have their roots in two different business cases. Passive products have the objective to give investors an exposure to the market or certain factors at a low cost, while active products bear the costs of gathering information and aim to find mispricings in order to exploit them, setting the right price and thereby making the market more efficient. Furthermore, passive investments need to be as large as possible to benefit from economies of scale and therefore minimize costs, while active managers’ returns decline when their assets surpass a certain size.
This by itself, leads to an interesting contravening pendulum in the market. At times, when stocks in the market are “efficiently” priced (result of price discovery of active managers) and as a result the advantages of being informed are reduced, passive approaches with their low costs seem most attractive. The result of an increased inflow in passive investments (investments without regards to fundamental value of the assets) opens the way for mispricings, i.e. inefficiently priced assets. Consequently, opportunities for active managers to exploit such mispricings grow. A recent paper called “Passive opportunities for active managers” made a very interesting analogy between a whale whose carcass falls to the bottom of the sea and subsequently sustains an entire ecosystem for years. Strong inflows of passive products will eventually provide hungry active managers the possibility and opportunity to harvest “newly generated” sources of alpha for years to come.
The strong demand for passive investments and its ensuing increase in market share lead to various distortions in the market place.
Passive investors subject themselves to forced buying and selling; changes in the index (the inclusion or exclusion of a stock) lead to immediate action irrespective of valuation or reasoning. Further studies show that stocks with index membership (S&P 500) trade at a substantial premium to stocks not included in the index. Additionally, stocks with a high passive ownership appear to trade persistently at a higher valuation than stocks with higher active ownership, controlling for size, region and sector effects. As one would suggest, studies revealed that, due to a higher degree of uninformed investors, stocks with passive ownership appear to react less strongly to news (e.g. earnings surprises) and mispricings can therefore be more persistent than stocks with a higher share of active investors do. As passive investing overlooks the starting point of valuation, which will determine one’s excess return in the mid- to long-term, opportunities for the active manager will arise on both sides. First, in finding undervaluation, and second, not being invested in overpriced companies.
“Ability is nothing without opportunity.” (Napoleon Bonaparte, 1769 - 1821)
At this point in time, with the MSCI World at all-time highs, expectations are high for certain regions such as the US and less high for regions of continued uncertainty such as Europe. As soon as perceived uncertainty in Europe decreases, expectations will rise leading to higher valuations and ultimately lower expected returns. Passive approaches generally fail to capture idiosyncratic opportunities; highly valued companies are systematically overweight while bargain stocks with low valuations are consequently underrepresented in market cap weighted products. Markets are mean reverting as a result of changes and markets´ psychology, which is often, maybe even predominantly a result of past performance. Also, active management becomes more interesting as perceived uncertainty about its future increases as less people are competing for price discovery.
To summarize:
- Starting Valuation is what matters: The expected return of a portfolio is reliant on its valuation at the time of purchase.
- Passive investing equals ignorant pricing: It structurally overweights expensive stocks while underweighting cheap ones.
- Smart Beta is not so smart: Smart beta products are just as good as their starting valuation. Multiples typically increase as inflows propel the constituent stocks higher.
- The Paradox: In times when stocks are efficiently priced as a result of active managers’ price discovery, passive approaches with their low costs seem most attractive. Strong inflows into passive products lead to inefficient markets and therefore opportunities for active managers.
- Valuation of assets with high passive ownership: Due to forced buying and selling (without regards to valuation), index constituents trade at a premium, inclusion and exclusion of stocks in indices have a huge impact and stocks react less strongly to news (uniformed investors).
- Extensive passive ownership leads to additional opportunities for active managers.
For truly active and benchmark agnostic investors with a high active share such as Lingohr & Partner, the massive shift into passive will lead to further mispricings and consequently provide opportunities to be exploited. Your judgement and skill-set needs to be different from the market in the long-term, having the same opinion as the market will not result in an excess return. For that very reason, you also have to bear the risk of being different – an important quality which requires a steadfast emotional approach. An independent asset manager like Lingohr & Partner has the opportunity to follow its convictions, diverge from the herd and therefore take the risk to appear “wrong” which is essential for a successful investor. Even though alpha is, in the financial markets, continuously exploited by the quickest, smartest or luckiest market participant, new alpha is repeatedly created as a by-product of investors´ cognitive biases, agency risk, emotional overreactions as well as herd-like behavior. Reliable alpha generation requires the development of a sustainable edge. We believe in our long-term proven process, focusing on finding bargains and combining factors into models which make conceptual and fundamental sense rather than looking for what might have worked in the past. One of the keys to our long-term investment success is hard work, great patience, strict discipline and maintaining your conviction. At Lingohr & Partner, we always stay disciplined and stick to our approach especially during periods of headwinds.
Lingohr & Partner Asset Management GmbH is a financial services institution as defined by the German Banking Act and is subject to supervision through the Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht - BaFin). Its registered office is in Erkrath, Germany.
This presentation is intended exclusively for individuals who, professionally or commercially, buy or sell securities or other investments for their own account or on behalf of others (institutional investors).
Lingohr & Partner Asset Management GmbH is the author of this presentation. Reproduction of this presentation, duplication of the information or data contained therein, particularly the use of text, graphics or image material, whether entirely or partially, is permitted only if specific approval thereto has been given by Lingohr & Partner Asset Management GmbH.
Lingohr & Partner Asset Management GmbH reserves the right to change or add to the information contained in this presentation.
Past performance of financial instruments is no guarantee of future results.
We do not provide any guarantees regarding the accuracy or completeness of the information.
Sources
1 EPFR Global und Bernstein Analyse, Jan. 2000 – Jul. 2016.
2 Arnott R., Hsu J., Kalesnik V., Tindall P. „ The Surprising Alpha from Malkiel’s Monkey and Upside-Down Strategies”. The Journal of Portfolio Management, Volume 39 Number 4, 2013.
3 Holcroft J. „ Passive Opportunities for active Managers” UBS Quantitative Monographs, Februar 2017.
4 e.g. Morck, Randall, Yang “The mysterious growing value of S&P 500” National Bureau of Economic Research, 2001.
5 e.g. Holcroft J. „ Passive Opportunities for active Managers” UBS Quantitative Monographs, February 2017.
