Passive Investments Plagued by Momentum

Passively managed exchange-traded funds are clobbering the performance of actively managed mutual funds this year. And brainy portfolio managers are starting to freak out.

A recent piece in The New York Times, “Tech Stocks Boom, but Some Stock Pickers Are Wary” observes that transformational change is afoot. As the title implies, finding value is no longer being rewarded because the vortex of big ETFs is essentially rewarding size over virtue.

Don’t feel sorry for Wall Street pros. They had this coming.

The idea of active portfolio management, or value investing for that matter, is that you’re supposed to be smarter than the market. You’re supposed to be able to find value where others cannot.

If the rest of the market mindlessly chases technology stocks simply because they have performed well, that should make your job easier. You should be happy. You get the opportunity to buy even more value at attractive prices.

Theoretically. Yet the pros worry that the game has changed.

I’m using the word “game” deliberately. For a long time, pros have had things easy. It’s true, they are better at finding value. They spend a lot of money hiring good people and kicking a lot of tires.

In the past, they would find value stocks and establish huge positions. Then the process of selling the idea to prime brokers on Wall Street would start. Slowly, positive research reports on Acme Inc. would circulate. Investment banks would raise their outlook for Acme to “buy,” and so forth.

Because many pro portfolio managers are shameless, they leave no stone unturned. Turn on Fox Business or CNBC and you’ll see them out there, talking up their portfolios.

It’s all perfectly legal. And everyone is complicit.

But make no mistake, what they’re all doing is working to pump up stocks that pros bought much cheaper, so it’s easier to dump those same shares on an unsuspecting public.

If it works, the pros get to pat themselves on the back for their stock-picking prowess. Analysts get to crow about a near-term pop in the stock as retail investors pile in. It helps the financial news networks and outlets, too.

Everyone wins, except retail investors.

Individual investors have been deserting managed mutual funds for passive ETFs — and ruining the best-laid plans of brokers.

What’s been happening is that the usually reliable army of retail investors is now funneling money into ETFs instead of individual stocks. The independent research firm Morningstar reported actively managed U.S. mutual funds last year lost $263 billion, while ETFs had inflows of $308 billion.

These machine-managed funds have low fees. They also make asset allocations based solely on a stock’s market capitalization rank in the underlying index.

Where it gets funky is that passive money ends up almost purely chasing performance. And most of the performance over the last few years has been concentrated in only a handful of mega-capitalization technology stocks like Amazon (AMZN), Alphabet (GOOGL), Apple (AAPL), Facebook (FB) and Netflix (NFLX).

These are stocks the pros are not buying because they’re trying to be smarter than the dumb market. Yet without a dumb retail audience to buy their other ideas, their performance can’t keep pace.

S&P Dow Jones Indices reports 88% of large-capitalization mutual funds trailed their benchmark indexes over the past five years.

And that is leading to an epic wave of whining and handwringing.

Benjamin E. Allen, who manages $15.6 billion at the San Francisco-based Parnassus Investments, needs to worry about tangential effects, too. Last month Amazon bid $13.4 billion for Whole Foods Market (WFM). His firm has significant exposure to deep-value picks Sysco Corp. (SYY), a food distributor, and CVS Health Corp. (CVS).

Amazon’s surging share price —  generated in part by passive investors chasing momentum — provides it with unprecedented access to cheap capital. It’s using that leverage to disrupt everything from food to potentially pharmacy. It’s already weighing heavily on stocks like Sysco and CVS.

“It’s stressful. We are competitive people,” Allen said. “I don’t like calling my clients up every quarter and saying ‘Sorry.’”

Poor guy.

I’m not endorsing blind buying of anything. I’m not a fan of ETFs or passive investing in general due to its momentum focus. For the members of all my services, I provide comprehensive research and discipline.

However, I have also made it my mission to expose the dirty tricks Wall Street plays to separate individual investors from their money. And I’m not sorry some pros are now under some duress.

Just like there’s “no crying in baseball,” there is no whining in investing. We find a way to merge the best of both active investing (seeking value) and passive investing (going with the flow when appropriate).

Best wishes,

Jon Markman

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Comments 6

  1. H. Horace Newberry July 10, 2017

    Over time, the best approach to investing is to find the direction that the majority of the pro’s are going, then run as fast as you can in the opposite direction.

    It’s the simplest way to beat the averages.

    Reply

    • H. Craig Bradley July 13, 2017

      TREND FOLLOWING INVESTING

      Wrong. Every investor today needs to find a way to follow trends with some of their money. Diversity of investing styles is best. The best approach is figure out which of the 9 major sectors in the S&P 500 Index are getting most of the institutional money (Big Bucks) and invest only in those top sectors with the highest relative strength and momentum trends. Invest in asset classes with similar strengths and mimic the big boys, who can not quickly enter or leave the market.

      When a market sector sufficiently weakens, sell it and move to the next strongest sector. This approach concentrates your money where it is working the most and avoids stalled or declining sectors. Another words, Go with The Flow. This results in higher risk adjusted returns, at least in theory. Right now, this investment approach working pretty well.

      Reply

  2. Greg Graham July 11, 2017

    Jon…..

    It is becoming difficult to pick any individual stock for whatever reason (especially value) because investors are pouring tons money into ETFs.

    When say investors pour tons of money into a Technology ETF, ALL OF THE STOCKS IN THE ETF GO UP IN PRICE because all of the stocks in the ETF must be purchased with new investments.

    This creates a situation where stocks that have no fundamental reason for going up in price do so. Even stocks that should be in decline go up instead.

    This is becoming a large structural problem in our equity and bond markets.

    The game has now changed from picking individual stocks based on good fundamental analysis to picking entire sectors via ETFs due to sector rotation.

    And when investors decide to rotate out of one sector and into another, you better be ready to run for the exits to be one of the first out the door.

    Reply

  3. Chuck Burton July 11, 2017

    ETFs MUST emphasize major stocks in their portfolios, to avoid creating too much volatility in the markets for small companies. For example, I hold an ETF, IPAY, which is doing well, concerned with the growing field of wireless payments. It’s major holding include such stocks as Visa, which is only minorly involved in the field, but which can absorb a sizeable portion of the fund’s money without too much volatility. The real growth though, is in the smaller holdings, which could more easily double, triple, etc., but doubtless, some government agency would frown on too much money going into such stocks. This holds down the growth of many ETFs.

    Reply

    • H. Craig Bradley July 13, 2017

      TRADITIONAL STOCKS BUILD THE MOST WEALTH

      I don’t think the Government is behind the asset allocation and company holdings of I-Shares or similar ETF’s. Rather, I believe they are structured to be less risky by following the largest cap companies, which often are the ones with the most momentum, as well. We have a large growth, momentum market today and for the duration of Janet Yellen’s low interest rate paradigm. Small company stocks are highly volatile and can ruin a fund’s ( Mutual or ETF) annual performance, causing retail investors with weak stomachs to bail fast, creating even more withdraws and attendant volatility. ( So-Called Vicious Cycle).

      So, if you really want to beat the Index or Sector benchmarks and build some real wealth, then you must buy individual stocks own your own. Today’s stockbrokers do not make much money on commissions and consequently do not promote individual stocks. Broker liability enters into their bias for funds instead. However, Brokerage Firm practices are not necessarily to the client’s best long term interest. Fiduciary means even more risk adverse. Suggest as a starting point, just pick some of the smaller issues within a given ETF and begin some company research- then invest. You take the risk and you own any rewards if you get it right. Plus, no annual account fees while you hold and patiently wait either. Buy at good value and lower your risks even more. Long term only with minimal trading.

      Reply

  4. Lynn Hayes July 11, 2017

    Thank you Jon!

    This was a really good article, as are most of your pieces. I appreciate your candidness regarding the way things work in the professional world. Over time, I’m learning more and more about that. I don’t like “mysteries” when my retirement money is involved.

    I’d like to be back in your trading service, but I’m limited in extra cash to invest right now. Hopefully, that will improve in the future. Keep up the good work– I love to read your stuff! 🙂

    Best,
    Lynn H.

    Reply