Introduction
A contrarian is always alert to the chances that a popular view is exaggerated. I believe that the generally accepted view that passive investing will become the dominant type of fund management suffers from exaggerated extrapolation of net flow trends. This is particularly true when relying on passive Exchange Traded Funds (ETFs) as the main or exclusive component to a long-term investment portfolio.
The Weaknesses in ETFs
There are four structural weaknesses in passive ETFs as follows:
1. Each passive ETF at the time of inception picks a particular portfolio in which it must invest and in a specified allocation. (An earlier version of today's ETFs were the Unit Investment Trusts which had fixed portfolios.) One of UIT’s drawbacks was when a security was no longer available to be purchased because it was acquired or went bankrupt, the UIT could not substitute another issue so it was a portfolio that was always looking backwards. In 2016 through the third quarter very few of the stocks in the S&P500 were rising and a small minority of the stocks were causing the institutional index to appreciate. In periods of large successful IPOs they may not get into various ETFs until after they have their initial surge.
2. Actively managed funds almost always have some cash to meet inopportune redemptions and as a reserve for new names to be added. (If in a sudden sharp decline the cash can be used immediately to meet redemptions and not hit panic level prices and/or buy some bargains. On the way up cash is a drag on performance, but it has proven to be a benefit to many portfolios.)
3. In the US only Authorized Participants can purchase or redeem shares in an ETF. (These are self-identified competing market makers who have bought a $250,000 creation unit in the ETF. To the vast majority of ETF players, they do not know who these "APs" are, or their capital and in what other activities they are engaged. In many big trades the other side of the trade will be a professional trading organization which temporarily stretches the AP's capital to a breaking point. It hasn't happened yet, but it could.)
4. The biggest single risk for many investors is the person making the investment decisions in terms of specific ETFs, size of investment, and timing of the transaction. (While the fees charged for passive funds are usually quite small compared to active funds with all their fees, expenses, and sales charges included, the portfolio manager of an ETF managed account is outside of its stated cost.) Also the commission charged by the broker supplying the trade to the AP is extra as well as the spread between the transaction price and the current net asset value is not revealed. However, the biggest weakness is that many of those who are managing ETF accounts are not as highly trained as the professional portfolio managers of most actively traded mutual funds in terms of choosing sectors, selecting securities, placement and timing of transactions and intelligent proxy maneuvers. At this point no one is tracking the long-term performance of these ETF Managed Account Managers.
Examining an Active Portfolio Manager as an Investment
An Important Caution
The manager that I will use as an example of how to look at this type of actively managed investment is one that is in the private financial services fund that I manage as well in my personal accounts. Further our investment advisory accounts own numerous of its mutual funds. I am not suggesting that you should buy shares in the manager or use their funds or accounts. Those decisions need to fit your particular situation and other investments.
A contrarian is always alert to the chances that a popular view is exaggerated. I believe that the generally accepted view that passive investing will become the dominant type of fund management suffers from exaggerated extrapolation of net flow trends. This is particularly true when relying on passive Exchange Traded Funds (ETFs) as the main or exclusive component to a long-term investment portfolio.
The Weaknesses in ETFs
There are four structural weaknesses in passive ETFs as follows:
1. Each passive ETF at the time of inception picks a particular portfolio in which it must invest and in a specified allocation. (An earlier version of today's ETFs were the Unit Investment Trusts which had fixed portfolios.) One of UIT’s drawbacks was when a security was no longer available to be purchased because it was acquired or went bankrupt, the UIT could not substitute another issue so it was a portfolio that was always looking backwards. In 2016 through the third quarter very few of the stocks in the S&P500 were rising and a small minority of the stocks were causing the institutional index to appreciate. In periods of large successful IPOs they may not get into various ETFs until after they have their initial surge.
2. Actively managed funds almost always have some cash to meet inopportune redemptions and as a reserve for new names to be added. (If in a sudden sharp decline the cash can be used immediately to meet redemptions and not hit panic level prices and/or buy some bargains. On the way up cash is a drag on performance, but it has proven to be a benefit to many portfolios.)
3. In the US only Authorized Participants can purchase or redeem shares in an ETF. (These are self-identified competing market makers who have bought a $250,000 creation unit in the ETF. To the vast majority of ETF players, they do not know who these "APs" are, or their capital and in what other activities they are engaged. In many big trades the other side of the trade will be a professional trading organization which temporarily stretches the AP's capital to a breaking point. It hasn't happened yet, but it could.)
4. The biggest single risk for many investors is the person making the investment decisions in terms of specific ETFs, size of investment, and timing of the transaction. (While the fees charged for passive funds are usually quite small compared to active funds with all their fees, expenses, and sales charges included, the portfolio manager of an ETF managed account is outside of its stated cost.) Also the commission charged by the broker supplying the trade to the AP is extra as well as the spread between the transaction price and the current net asset value is not revealed. However, the biggest weakness is that many of those who are managing ETF accounts are not as highly trained as the professional portfolio managers of most actively traded mutual funds in terms of choosing sectors, selecting securities, placement and timing of transactions and intelligent proxy maneuvers. At this point no one is tracking the long-term performance of these ETF Managed Account Managers.
Examining an Active Portfolio Manager as an Investment
An Important Caution
The manager that I will use as an example of how to look at this type of actively managed investment is one that is in the private financial services fund that I manage as well in my personal accounts. Further our investment advisory accounts own numerous of its mutual funds. I am not suggesting that you should buy shares in the manager or use their funds or accounts. Those decisions need to fit your particular situation and other investments.
Why Focus on T Rowe Price?
This weekend when I started to do my note-taking for this post I saw two things that caught my eye. The first was that so far in 2017 many of the funds that were performing well were International funds with a heavy emphasis on Asia. The leader in this particular computer screen I was examining was T Rowe Price New Asia, which was doing well after laboring through most of last year. This reminded me that the management company is opening a series of international sales offices. As many of our readers have learned, I believe that there is a global shortage of retirement capital. In many, particularly Asian, countries there is a strong savings ethic, but not a fully developed mutual fund market.
The second thing that I noted was on Thursday the stock of the management company opened down by 3% and continued to fall the rest of the week. At the low on Friday it had declined 9% from its Wednesday high and now trades a full ten point decline from its 52 week high. The cause for the decline was the release of T Rowe Price’s calendar year earnings report. Unlike most of the financial stocks, the company does not hold earnings conference calls, but issues quite complete releases that you would expect from a firm with an army of analysts and significant employee ownership.
As is often the case it wasn't the announced fourth quarter earnings which were slightly above the average analysts' estimate, it was the "Other Events" three paragraphs that evidently shook out some holders.
For the first 3 days of
the week the average volume was slightly below 1.5 million shares, on Thursday
it was five times that at 7.6 million shares and 4.6 million on Friday. The
essence of the three paragraph note was that in the fourth quarter there were
outflows of $1.9 Billion from the Target Date funds and $6.3 Billion in net
inflows for the year.
With about 2/3rds of
the firm's assets in retirement accounts depending on conditions in the market,
there can be a significant amount of exchanges between retirement accounts and
the Target Date funds. In examining these flows/exchanges with various accounts
and Target Date funds, it was determined that the fourth quarter outflow was
$63 Million and an inflow for the year of $8.1 Billion. These disclosures did
not change the overall outflows of T
Rowe Price funds for the 4th quarter of $2.8 Billion and $5.0
Billion for the year 2016. The firm noted that net cash outflows were largely
caused by institutional and intermediary clients reallocating to passive
investments.
The Way a Contrarian Sees the Situation
As someone who has served on various institutional investment committees, I have experienced the pains of under-perceived trend performance and understand the strong desire to go passive and get the performance bug off one's back. Unfortunately much of this tendency is based on conformation bias. On a casual basis up to the election, which should not have been a surprise to good data analysts, the various market indices were out-performing most institutional accounts. Too few investors recognized the positive effects of gradually rising interest rates from last summer. When investment committees move they often do it slowly and often wait until the later part of the year. Thus the shift in the fourth quarter is not surprising. What I find disheartening is the ETF discussion above. A somewhat similar set of issues are involved with other passive techniques.
Relative to other large mutual fund complexes T Rowe Price has the best long-term record of out-performance of peer funds. As previously mentioned it is expanding its global sales efforts and is increasing investment into internal technology along with some other leaders.
As regular readers know, I believe in dividing an investment portfolio into various TimeSpan slices or portfolios which I have named TIMESPAN L Portfolios®. I have placed the stock of T Rowe Price in the long-term endowment portfolio as a good representative of the expected growth of global retirement capital. With the current decline in its stock, TRP is now yielding over 3% compared with the yield on the market averages of about 2%. Further, the yield over time is likely to rise if T Rowe Price continues to buy back stock in excess of internal needs.
Implications
You can use a similar or even better approaches to investing in a contrary way. Good Luck.
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A. Michael Lipper, C.F.A.,
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