New Century Investment Management, Inc. – Active Management White Paper

  • New Century Investment Management, Inc.
    Active Management White Paper By Jeffrey D. Modell, Esq. and Mark C. Lahti, Esq.
    Telephone: (248) 262-3140

    October 26, 2016

    As Cleared for Distribution November 1, 2016

    Active managers have had a hard time since the 2008/2009 crash. Further, a report by S&P Global
    concluded that 90.2% of the actively managed U.S. domestic equity mutual funds underperformed their
    benchmarks for the twelve-month period ending June 30, 2016. Our category, large cap growth style,
    was up 2.26% for 2016 through October 25 based on the Morningstar™ category (which is net of both
    management fees and custodial fees) whereas the Standard and Poor’s 500™ Index, which includes both
    growth and value elements but is a fair benchmark over a full market cycle, was up 6.70% and the
    Russell 1000® Growth Index was up 4.94%. Some of this is fees, some is a lack of talent, some is the
    measurement period.

    True skill is rare. Most investment managers lack a rationale investment system. Some have a good
    system but lack the discipline to implement it through thick and thin including multi-year periods of
    underperformance. Sometimes flailing (typically demonstrated with unusually high trading activity) is
    driven by client pressure. Sometimes there is an internal policy at the management shop that requires
    underperforming managers to mimic their benchmarks to help prevent customer attrition. Some active
    managers have a good system but attract so much money that their market impact during trading makes
    it impossible to profit. A number of managers who grow out of their britches quietly modify their strategies
    to add positions and increase market cap in the hope of being better able to cope with excessive pools of
    assets instead of closing the product to new investment at a manageable level.

    Studies have shown that emerging managers, which tend to be defined as shops with less than a few billion
    funds with allocations specifically targeting emerging managers. The difficulty in the emerging manager
    arena is identifying the small shops with talent, adequate controls and financial staying power. You can’t
    do that by just screening a manager survey database or kicking out a rote RFP, you need a specialized
    consultant with the intelligence and creativity to understand the strategy, know the people and kick the
    tires. It is easier for a large shop to have established systems and staying power but it is still possible for
    a larger manager to have just one person who actually understands the strategy and for that person to
    leave.

    True skill is rare but it does exist. It is statistically possible to rule out the possibility that a sufficiently
    comprehensive stream of good investment performance is the result of luck. That is no guarantee that
    markets will not change so the system ceases to work over a specific time period or ever again, or that
    the investment product will not suffer one of the bad fates noted above. The SEC effectively requires
    managers to state that past performance is not indicative of future performance. We do not disagree with
    that but I find it more helpful to remember past performance is no guarantee of future performance. The
    race does not always go to the fastest but that may be the smartest way to bet.

    Active management depends on rational market environments. That means there is a correlation between
    a company’s fundamentals, the broad economic environment and stock pricing, over a
    reasonable measurement period. The post-2008/2009 markets have been characterized by hedge funds,
    high frequency trading, and stock market behavior keyed off geopolitical and global events including
    macroeconomic crises, reducing the degree to which stock price movements reflect general and company
    specific reality. Our internal study using an aggregate of indices put out by the CBOE shows the price
    correlation of all the stocks within the S&P 500 doubling from early 2007 to a post-crash high.

    You may heard a market pundit say that active managers have difficulty picking good stocks when all
    stocks move in tandem. We form our own opinions and see it differently. Most active managers lack
    talent and have difficulty doing well regardless. It is the talented managers who have been suffering.
    To add insult to injury low quality speculative stocks – companies at serious risk of going under and
    which would flunk any reasonable due diligence – are a part of many benchmarks and thrive when sentiment
    turns from doom to positive. Active managers are typically prohibited by their institutional clients from
    investing in these stocks and/or have internal guidelines prohibiting owning them even if some limited
    exposure would benefit the portfolio as a whole. Clients simply will not put up with an active manager
    who regularly owns companies that go under even if overall performance is good.

    If you look at an active manager during only that part of a market cycle when their system is ineffective
    it will not be a good picture. Market cycles vary in length but must include sufficient time when the major
    style boxes are in and out of vogue so that the aggregate measurement period is representative of normal
    markets and a fair shake to all parties. Much of that relates to the economy in a direct or indirect fashion.
    Market cycles are seldom an arbitrary fixed period however convenient. Even pension fund officials may
    lack the patience to wait out a full market cycle and end up firing world-class managers at exactly the
    wrong time. In our opinion we have not seen a full market cycle for the period commencing with the past
    recession. The economy has yet to improve from tepid growth to strong or from fragile to solid.
    Passive investments have a number of advantages. ETF’s and mutual funds have lower fees than active
    long-side managers.

    Index vehicles can have hundreds or thousands of stocks including those speculative stocks that
    fiduciaries find problematic should they appear on a portfolio inventory. Index based vehicles are far
    more actively managed than most investors realize. One of the major index firms included Exxon Mobil
    Corporation in its large cap “growth-style” index and it was nearly 4.5% of the index! No reasonable
    fiduciary would have classified Exxon as a growth stock at the time. They later eliminated it in one day
    cutting the energy sector precipitously. Periodic index “rebalancings” can have a material impact on
    benchmark performance.

    An index is a lot like a Frankfurter. It is a delightful meal so long as you do not know what goes into it.

    Index investments are not the most risk efficient portfolios since nothing is done to alleviate systemic
    risk though we hasten to add not all managers have the same philosophy and expertise on risk management
    or target on the risk/reward spectrum. A risk efficient portfolio may have materially better or worse
    absolute performance than its benchmark during any specific period of time. A good index fund should
    avoid the stress of material underperformance versus its benchmark during all periods absent
    extraordinary conditions.

    Passive managers do their best to track their benchmark closely but there are differences in the quality
    of those efforts. Index vehicle providers must conform their portfolios to benchmark changes, and also
    experience cash inflows and outflows that require significant trading. The better passive managers use
    futures and other complex instruments to minimize the cost of these transactions. If the market is
    crashing, there are insufficient buyers for many of the stocks in the index because everyone is selling that
    index that day, and a client decides to sell out, the passive fund manager will do his best under the
    circumstances but there are consequences.

    From the “Nifty Fifty” (in the 1960’s, 50 stocks you could buy and hold forever, until they got crushed)
    to the internet boom (when page views mattered and earnings didn’t), from investments in collateralized
    mortgage pools (how many AAA rated pools fell to zero I wonder) to high fee black box hedge funds
    chosen by institutional investors with the mistaken idea that non-bond securities would actually provide
    bond-like protection when the market collapsed, the one constant is the belief that there is a sure thing.
    Investing is a lot like fashion. You can own clothes that are in style and clothes that are out of style but
    you do not want to be the person wearing the Emperor’s New Clothes.

    ETFs pose a systemic risk to the market and your pocket book but only when it really matters. When
    hedge funds whip massive amounts of liquidity around these vehicles get wagged like the tail on a dog.

    “Portfolio Insurance” is also back by another name. For those of you too young to remember, the idea
    was to dynamically use tiers of options to protect a long portfolio from a crash. It had the exact opposite
    effect during the 1987 crash; the insurance caused a downhill stock market snowball. When a calamity is
    so severe that the financial system is at risk, hedge funds have jettisoned their long holdings and go
    massively short index futures, and high frequency traders accelerate the trend with their own trading and
    by scaring potential buyers out of the market, the corresponding ETFs will plummet soon followed by the
    index mutual funds. Portfolios less correlated to these indices will at least stand a chance. That is a
    pretty bad fate but it is not the worst potential wealth destruction outcome.
    No one talked about the possibility of a money market fund breaking the buck and gating redemptions
    when individuals poured out of banks into money markets. There could also be catastrophic
    consequences to the operation of the passive investment vehicles during a meltdown. We call an illiquid
    micro-cap stock a “roach motel” because you can get in but not out. You can easily get out of those
    popular index funds today or during a “normal” crash. What happens when index ownership is at a new
    high, the market is down so far every passive investor wants out of the exact same stocks at the same
    moment, and all of the bad actors are accelerating prices lower with computer-generated programs and
    ultra-high speed connections? What prices will be quoted for the stocks in the index or for an ETF? What
    price will the actual fills come in at? Will index fund managers be able to timely dump the stock they
    must, even at any price, to fill the redemptions? If it all goes south and their operations fail the only time
    it really matters will these management firms be willing and able to dip into their own pockets like some
    brokerage firms did after putting clients into problematic money funds?
    Do not ignore the systemic value-creation risk from too much passive investment. Think of the growth in
    the U.S. economy during all those years before index funds became the thing. Back then the stock
    market was able to allocate capital where it could do the most good and that drove industry. The good
    economy then pushed the indices up. The more money we invest on auto-pilot the poorer will be the
    return on the benchmarks and their corresponding passive investments. Perhaps this longer term issue

    has already put drag on the economy.

    In our opinion the best reason for staying with active managers is the timing. One of the greatest value
    managers in the world decided to hang up his shingle after an extended streak of bad performance. That
    was the year before value-style took off. Index funds have done so well everyone and their brother is
    recommending them and piling in. Active managers have not done well. Investing is not a field where
    you can buy high, sell low and make it up on volume.

    The S&P 500 internal correlation has declined from its high but is not down to pre-crash levels. The latest
    numbers are heading in the right direction but nothing decisive. Nor has the SEC shown an inclination to
    enforce existing securities laws that would reduce the abuse of equity markets by hedge funds and high
    frequency trading firms.

    What would do see, however, is stock market behavior more reflective of the true measure of economic
    affairs and a company’s outlook. There is a more realistic weighting of global events and a quicker
    readjustment if the knee-jerk reaction was excessive. The Brexit dip is a great example; a modest
    overreaction followed by a quick rethink rather than an accelerating cycle of international equity market
    destruction. There are plenty of bad things happening in the world now that a few years back would have
    decimated equity markets and perhaps resulted in another recession. That has not happened in 2016.

    Consequently we anticipate more normal equity markets, the kind where talented active managers can
    add value.