Investing

Passive Investments Plagued by Momentum

by Jon Markman | July 10, 2017

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