On Indexing
With the spate of articles and analyses of how index investing is superior to active management, it is time we weighed in on the topic. We acknowledge that the average active manager has not outperformed their benchmark index for the past few decades. First of all, the point is moot in our view because human nature would prevent almost anyone from inactively holding all their investment assets in an index for decades. Second, a meaningful number of active managers handily outperformed their benchmark index during the stipulated time frames. Finally, we believe interest rates are artificially low and will rise. History has shown that a rising interest rate environment is especially conducive to outperforming a benchmark index.
One of the most widely referenced stories conveys that Warren Buffett has set up trusts for his heirs in which the trustee is instructed to hold 10% short term bonds and 90% S&P 500 index. What is adequately noted by the public is the allocation choice, and we too think it wise. But the most important aspect, which by the way we have not seen noted, is that Mr. Buffett felt the need to have a permanent long term policy and a trustee in place to hold this allocation. Our interpretation is that he realized almost no one could resist the temptation to deviate from the index in a wide range of environments that are sure to exist in the coming decades. As Mr. Buffett has said, “Investing is simple, but not easy.” Advising someone to hold indexes indefinitely implies that investing is simple and easy. If it were feasible to expect someone to hold an index, Mr. Buffett would have cut out the trustee fees and given heirs an index fund. “Just own a few index funds for the next twenty years,” will probably work as effectively as, “Only eat healthy foods and exercise five days a week.”
We previously cited a Pogo comic, “We have met the enemy, and he is us.” Adding to that, it is important to note that, jealousy, envy, and greed are at the root of most regretful behaviors. When there is another bear market year like 2000, in which over 70% of large and small cap managers beat their benchmark indexes, it seems complacently naïve to think most investors will be able to remain inactively invested in an index while neighbors, friends, and family experience better returns. Jealousy, envy, and greed are highly likely in our view to interfere with one’s ability to steadfastly hold an index.
Index investing is so boring that it is hard. People seem to always want a little more and to do a little better. A representative of a mega sized ETF company estimated that in the last year his company introduced about twenty new “enhanced index products”, which suggests to us that investors do not really want to own simple indexes. One enhanced index product had 98% turnover in 2014, which is on par with a hyper active manager.
Active managers, excepting corporate raiders, provide an important voice. Last year there was a battle royal over the exorbitant compensation of Coca-Cola executives. Index managers did not seem to notice or care because their daily task is simply to replicate the index.
About 2014
Artificially low interest rates have had a major impact by allowing weak companies to survive by issuing debt on ludicrously beneficial terms. The 100 most debt laden companies in the S&P 500, with debt to total capital averaging 75% (i.e. 75% of their business is funded by cheap debt), posted total returns of 21.3% on average. At the same time, the 100 worst returning members of the S&P 500, averaging -13.5% total returns, had only 32% of their business funded by debt. Solid businesses do not need much debt to thrive. Mediocre and risky businesses need lots of cheap debt to have a chance to succeed.
About the intermediate future
A recent Barron’s article observed that as interest rates rose from 1962 to 1981, mutual fund managers had no problem outperforming the S&P 500. The average fund outperformed by 3.2%/year during this thirty year period. As interest rates fell from 1981 to 2014, the average fund underperformed by 1.5%/year. We think this observation is extremely important, and are quick to point out that when managers outperformed, the typical holding period of a stock was measured in years- in stark contrast to today. We have often joked that our style of investing would have been in vogue in the 60’s. While not speaking directly to the returns of our longest tenured clients, regulatory compliance allows us to share that returns of the managers we most admire and hope to have much in common with have handily exceeded benchmark returns in recent decades- though few outperformed in 2014. The primary common thread we see among these most admired managers is that they own stocks of good businesses for years on end, which would have been normal from 1962-1981.
The chart on the final page shows a history of the US unemployment rate. It is no wonder that US consumer confidence has risen dramatically in recent years as the unemployment level has dropped. Two sobering things jump off the chart. First, the bottom in unemployment clearly corresponds with the grey bars that indicate an economic recession. Second, it has been six years since the last recession. The US employment environment is favorable and is fostering slow and steady economic growth; we think it will continue to improve for some time. And while there is no data to suggest an economic recession is imminent, we are constantly on guard as one will eventually occur.
Almost a third of the S&P 500 companies have credit ratings that would make us shiver and all but prevent us from considering the company for purchase. Rising interest rates will make for an exceptionally difficult operating environment for this large swath of low quality indebted S&P 500 companies. Our strategy for outperforming the S&P 500 as interest rates rise is simply to own high quality companies while the index is hampered by struggling low quality companies. Likewise, our strategy for outperforming the S&P 500 in a recessionary bear market is simply to own high quality companies. Simple, but not easy.
