Why ETFs Are Inherently Anti-Value – The Passenger by Dave Iben, Kopernik Global Investors

“Oh, the passenger
How, how he rides
Oh, the passenger
He rides and he rides
He looks through his window
What does he see?
He sees the sign and hollow sky
He sees the stars come out tonight”
— Iggy Pop

Was Iggy referring to drugs or had he anticipated the beauty of ETFs circa 2016? Reviewers suggest that ‘he sees how wonderful everything is once he relinquishes control, becomes the passenger instead of the driver.’ Longtime readers know that I have a proclivity to view many songs and movies as metaphors for the investment world. In this case, passive investing, de rigueur in the marketplace, comes to mind. The “old school” investors labor over 10-Ks, 20-Fs and other regulatory filings, struggling through those boring ‘notes to the financial statements,’ and ‘pounding the pavement’ to perform due diligence via site visits and industry conferences, while vigorously ‘interrogating’ company management teams and then spending hours building valuation models. Meanwhile, the passive investor hops aboard the ETF du jour and he rides and he rides.

He/she enjoys generally high levels of trading liquidity, and the ability to quickly gain exposure to desired industries, sectors, regions, and cap ranges. Fees are minimal and taxes can be managed. Tracking error can be kept very low, a source of much relief to many. Much of the ‘unseemly’ ‘rolling up of the sleeves’ to perform tedious bottom-up, fundamental analysis can be dispensed with. While active investors are laboring away, the passenger, he rides and he rides.

The driver must contend with the ‘back seat drivers.’ Why did you turn that direction? This road is boring, that one, too crowded. Can’t you drive faster? When will we get there? And the passenger? He doesn’t have to explain short-term problems with individual stocks to clients. He doesn’t need to defend volatility or tracking error, or conjure catalysts. No, he rides and he rides.

“And everything looks good tonight
Singin’ la-la-la-la-la-la-la-la”
— Iggy Pop

Sitting here, well into the 21st century, on the footsteps of the era of the driverless car, robo-advisors, and virtual reality, Kopernik hereby takes on the arduous task of defending ‘reality.’ This Commentary puts forth the case for active management. To jump to the conclusion, we believe that there is a need for diligent investment research. We believe that there is an investment return on independent thought, on hard work, on willingness to bear the discomfort that goes hand in hand with contrarianism. In the current environment that return is prospectively quite high. The performance battle between active/passive management is cyclical in nature, and once again it is time to invest actively. While we concede many of the virtues of passive management, it is clear that it has its pitfalls as well, which are being overlooked. The case for passive investing assumes just a few ‘passengers’ taking a free ride on the back of a market made ‘efficient’ by millions of investors working hard to gain equal access to information, staying rational at all times, performing analysis to derive a fair price, and always paying that fair price. Even if one were to believe that people are rational and that markets can be efficient, once there are too many passengers relative to too few drivers, the theory goes out the window. At that point, the premise is nullified; the tail is wagging the dog.

The Dog Days for Active Management

It was an honor to be invited to speak at the London Value Investor Conference in late May. It is clear that these days are indeed uncomfortable, figuratively muggy, for value investors. In fact, even at a value conference, more than half of the audience preferred to be viewed as ‘franchise’ investors. It seems that the maxim “everyone owns quality growth stocks” is not far off the mark. It’s worth noting that it was much worse last year when, apparently, the vast majority shunned the value classification. Still, at this juncture, all investors that continue to adhere to a value-based discipline must be asking: Is the stigma fading? Are the dog days finally winding down? Time will tell – either way, a discussion on passive investing may be instructive. It’s important to start with the disclaimer that we’ve never believed that ‘growth’ was the antithesis of ‘value.’ It is merely a wonderful attribute that increases intrinsic value. ETFs on the other hand………

There were many interesting speakers, including Jean-Marie Eveillard, Howard Marks, and James Montier, all of whom I’ve admired for many years. I highly recommend the conference and plan to attend again in the future. I mention the conference because, among the many great presentations was one called “Passive Aggressive: The Implications of ‘Industrialized’ Capital Allocation,” by Michael Keller, a Partner of Brown Brothers Harriman.

Mr. Keller addresses a quick history of capital allocation, highlights the size of the current market for passives and illustrates a handful of their benefits and drawbacks, and segues to the larger implications of industrialized capital and passive investment. I found many of his bullet points to be interesting and well worthy of passing along.

(Below is a summarized version of his slides, to which we’ve taken some editorial license)

ETFs, Active Management

ETFs, Active Management

ETFs, Active Management

ETFs, Active Management

ETFs, Active Management

Passive funds have continued to take market share in the asset management business globally. The “active” industry is now only four times bigger than “passive”, compared with 8.5 times in 2007. – GREED & fear, Chris Wood, CLSA

ETFs, Active Management

It is worthwhile to add that the third party determining the index does not even try to identify the most attractive investment candidates, nor do they claim to.

Mr. Keller then featured the following quote from Glenn O’Donnell, Forrester Research 2010: “A process or profession becomes industrialized when it matures from an art form to a widespread, repeatable function with a predictable result and accelerated by technology to achieve far higher levels of productivity.” This evolution from an art to an industry is interesting. A third of a century ago, I believed that our business was 80% science and 20% art but now view the ratio to be roughly the inverse. Not to be misconstrued, the science portion is important. In fact, it is prerequisite. But, as Charlie Munger points out, a multidisciplinary approach is necessary. Many of the things that managers put forth as competitive advantages are merely the bare minimum of attributes that a good manager must have. The edge comes from augmenting the math and science with the arts. One must consider economics, history, psychology (crowd behavior), philosophy, integrity, generosity, aptitude, incentive structure, and so much more. Mr. Keller seems to be laying out a powerful case that the investment industry’s vast and impressive increase in efficiency has not served the clients well. It has inadvertently done the opposite. The proverbial forest has been lost in the trees. He points out that the mindset has shifted from managing securities to managing exposures. Kopernik would say, it has shifted from investing in companies to speculating on trends. He makes the important observation that a systemized approach may sound reasonable but it doesn’t work well in real life since “the market is not a repeatable, solvable system.” It is affected by human behavior, unpredictable events, and exogenous factors. Also, systems tend to look backwards creating the “risk of constantly ‘fighting the last wars.’”

Why ETFs are Inherently Anti-Value

“I am a passenger
I stay under glass”

It is time to put the passenger ‘under glass.’ Let’s use the magnifying glass. In our past Commentary (“When”-ing isn’t Everything), we discussed how good analysis requires the rigorous use of questioning. Regarding ETFs: Is the ‘science’ of investing incorporated in the construction of ETFs? Is the ‘artistic’ side of investing incorporated in the construction of ETFs? Is the wisdom of Munger, Templeton, Marks, Klarman, Rogers, etc., etc., etc., incorporated in the construction of ETFs? Do the assumptions underpinning the efficient market hypothesis hold in the contemporary world of ETFs?

Mr. Keller devotes a slide to the anti-value (my words) characteristics of ETFs and to the resultant “Opportunities for Value Investors.”

ETFs, Active Management

His subsequent slide entitled “Differentiated Active Management Shines Over Full Cycles” demonstrated that the vast majority of managers that have outperformed the S&P 500 over a 10-year period, had high active share combined with moderately low turnover. (He sources eVestment and BBH analysis). We, at Kopernik, are particularly pleased with this finding.

Before moving on to the next section, a few examples of the monsters that can result as the unintended consequences of good ideas.

From the Financial Times on May 30, 2016

“The research group Morningstar classifies 25 ETFs as low volatility funds, with $35bn in assets at the end of April, $9.8bn of which had been invested in the first four months of the year. The pace of inflows picked up sharply in February, after stock markets gyrated with fears of a global recession.

Money has kept being added, even though the Vix index of market volatility has fallen back close to a one-year low. The six largest low vol ETFs alone had further inflows of $1.6bn in May.

The $13.1bn iShares Edge MSCI minimum volatility USA fund from BlackRock, which has doubled in size in the past 12 months, has had inflows on all but three days so far this year. A $7.1bn sister fund that runs a minimum-volatility portfolio of non-US stocks has had inflows on every day but one this year.”

The article quotes Jeffrey Gundlach, “Low volatility stock funds are probably the most dangerous thing out there.” We tend to agree, but it will be interesting to see how posterity judges them relative to negative yield bonds.

ETFs, Active Management

“Nobody told me there’d be days like these
Strange days indeed strange days indeed
Everybody’s runnin’ and no one makes a move
Everyone’s a winner and nothing left to lose”
— John Lennon

Another example of good no longer being good when it becomes overdone is the Nifty-Nine (The infamous FANG stocks plus Priceline, Ebay, Starbucks, Microsoft and Salesforce (apparently coined by Ned Davis Research)).

The Pools of the late 1920s, the bank trust departments of the early 1970s, the index funds of the late 1990s and the ETFs of the current era have much in common. All were times of easy money, of great leaps forward in technology, and of people confusing good companies and good ideas with good investments. All were times when momentum investing was very popular, when crowd psychology created bubbles. We have all seen this movie before.

Why ETFs Are Inherently Anti-Value - The Passenger

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