For the last two years, Murray Stahl and Steve Bregman of Horizon Kinetics have published a “Compendium Compilation” of their various research pieces and market commentaries throughout the year. I recently requested copies of the 2014 and 2015 compendiums and just completed reading through the 2014 compendium.
The Scourge of Indexation
The single biggest trend that Stahl and Bregman have been criticizing for years is the rise and dominance of indexation as passively-managed ETFs as the practical consequence of widespread adoption of the Efficient Market Hypothesis. I collected comments from several different essays and stitched them together into a meta-commentary on the phenomenon:
We are reliably informed by many academicians that growth, value, momentum, yield and volatility are fundamental attributes for portfolios and, as such, are the determinants of performance. Numerous studies assert this as true. However, the studies were all done on the opportunity set of stocks, not actually on funds organized upon the findings of the research. In other words, these studies predate the implementation of the conclusions of the studies.
The efficient markets hypothesis is subject to no serious scholarly challenge. Indexation is by far the largest investment strategy and it is growing in acceptance by the day.
One could argue convincingly that markets are efficient if the market place is made up of a multiplicity of active managers gathering information and, by their trading, expressing that information in the prices of securities. However, as we saw in the Facts and Figures section, if the majority of the dominant investors, who are also the marginal buyers and sellers, are now passive, and if this dominance is growing, how can one be sure that the efficient market model remains a valid assumption?
What does it mean when one — that is, the investment ecosphere — creates multi-trillion-dollar managers that are valuation indifferent?
You cannot merely have trillions of dollars invested in indexes and assume that everything will be the same as it was before they were investing in indexes.
For 40 years, indexation worked because of four trends. There was a strong fiscal stimulus to promote the demand in most countries. Companies engaged in cost-cutting and eliminated marginal products and divisions, thereby increasing margins. Corporate tax rates have been declining for 40 years, and interest rates have been declining for decades. Companies, however, cannot count on those four benefits anymore.
We are going to replace poor judgment with no judgment whatsoever.
…an unintended consequence of the indexation movement is the creation of quasi-permanent holding companies for [S&P 500 and other major index stocks]
To my mind, the rise of indexation represents something of a corporate governance crisis in this country and any other where passive index funds account for a substantial proportion of the total shares outstanding in the market place (for purposes of this argument, I’ll peg that number at 20% which just so happens to be how much are currently owned by passive funds according to a recent New Yorker piece). Looked at in very simple terms, that is 20% of the shares of the average public company that have no active agency behind them, that is, there is nobody scrutinizing the operations of the company and the efficacy and honesty of its management by or on behalf of the shareholder whose capital is at risk. Given how many individual and even institutional shareholders are already “actively disengaged” from their duty to provide capitalist oversight of the companies they own, this is a troubling context to invest in if you believe that sound corporate governance is a key ingredient for above average investment returns and safety of capital at risk.
It reminds me strongly of one of the quotes from my recent review of Panic, “Underpinning the ideology of modern finance is the notion that the insight, judgment and even diligence of the entrepreneur are irrelevant for investing in public securities markets. These markets, we are told, are special, too powerful and too perfect to allow any entrepreneur’s judgment to matter.”
This indexation phenomenon has gone beyond influencing the markets to the point that it is “making” them, an inevitable consequence of gamification:
BlackRock… has issued a call for reform… [their] paper calls for the standardization of features of newly issued bonds. For example, an issuer would not be free to issue bonds with any features it wanted; it would have to issue them in certain standard packages, which are defined in the paper. BlackRock’s proposed change is an example of how indexation as a business is beginning to reflect the market as it impinges upon the index providers’ business needs.
Bonds have different characteristics because they represent different kinds of risks with different kinds of borrowers and lenders. While it’s possible to standardize anything for most applications, this is decidedly a “new era” where the standardization process is not being driven by the desire to reduce costs and confusion for borrowers and lenders per se, but rather it is being driven by the desire to efficiently index such media whose performance can then be captured in an ETF. It’s an important difference considering the fact that risk can not be standardized away just so that an investor can more easily allocate his funds.
In time, these indexes just end up playing themselves, as Stahl warns:
It is important to keep track of how the indexes are going to be tilted because that has two sets of implications. First, it has implications for the businesses of the index orchestrators, but second, it has implications for the entire marketplace. Whichever way a given sector gets tilted, either positively or negatively, the amount of money involved is so huge that it is going to be either the best-performing sector or the worst-performing sector.
Some Other Strange Side Effects Of Indexation
I captured a few other anecdotes related to indexation and EMH that I thought were memorable. One concerned the changes occurring in the utility industry. Stahl shared numerous statistics demonstrating the rapid rate of increase in solar power production, explained the different economics of solar (especially once installed) compared to gas, coal or nuclear powered generation and then surveyed the effect that the reach for yield and the indexation of the utility industry have created “priced to perfection” conditions in the publicly traded utilities firms. He concluded:
The asset allocation to yield-oriented stocks relies upon historical data regarding stability of dividends, which date back decades. The allocators treat this data as if they are immutable, scientific constants… They are completely unaware that a dividend quality constant is about to manifest a certain degree of inconstancy… This is an important phenomenon happening in the world of utilities, and people should remain very cognizant of it.
He also commented on the role volatility plays in the EMH:
In theory [institutions] are all fleeing volatility, but in reality are they merely fleeing volatility or, said another way, is volatility merely wherever they are going to be?
Connected to that idea is the degree of correlation which many investments are experiencing:
One can sell all of one’s investments and replace them with gaming stocks, and still have a correlation of 0.9726 with the S&P 500. It is an incredible statistic when you think about it.
Why should a presumably rational investor buy the more volatile Russell 2000 Index for a long period of time only to see it fail to outperform, or even underperform, the less volatile S&P 500 index?
And he brought further scrutiny on the idea of boiling down the predictive performance of a stock to one or two variables, such as volatility:
Companies possess many characteristics so it is difficult to assign causative factors to any one of them without knowing the other characteristics in that factor universe.
I also enjoyed Stahl’s commentary on including land in one’s diversified portfolio (again, these comments are stitched together from various essays):
Land held its value during the Great Depression.
Comparing and contrasting land with gold, it is clear that there were many periods when gold did not appreciate.
Government regulations sometimes affect the value of gold, but it is hard to envision government regulations that would affect the vast panoply of land resources in the world in some uniform way. Therefore, land is worth considering as a portfolio asset.
Land is not a hedge against political instability, which gold is because gold is mobile. Land is not mobile so it is only a hedge against inflation, not against political instability. Sometimes political instability and inflation come together.
He shared a contrarian view on eliminating an equity from consideration simply because it carries a high earnings multiple:
We cannot merely assert that if a company trades at 57x earnings, we will dismiss it as an investment. That would be an escape from reality… a Google at 15x earnings would be preposterously valued.
As long as it is possible to create companies at this scale of revenue, then not a few companies will trade at high P/Es. it looks like it is going to be a permanent part of the investment landscape.
Google’s valuation at the time it went public was around 57x earnings, and it’s market cap exploded from there. An interesting question is why it wasn’t valued even more highly given its realized potential?
Stahl observed a dichotomy between bond market interest rates and duration:
The interest rate is more or less engineered by the Federal Reserve, but the weighted average life reflects the risk preferences of bond investors.
Finally, I really liked this “bubble” related quote he shared from G.K. Chesterton:
There are no rules of architecture for a castle in the clouds.