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ETF Distortions – Horizon Kinetics 1Q17 Commentary

Horizon Kinetics 1st Quarter Commentary, April 20, 2017

“One needs be less diversified, so that one doesn’t overlap into the same systemic risks. Fewer securities, but with sufficient idiosyncratic features and optionality. Paradoxically, that is now what true diversification is.”

We’re Going Mainstream

  • In the past, we’ve titillated you with startling examples of the distortions caused by the indexation vortex:
    • iShares Frontier Markets ETF (FM), labelled as 91% lower risk than S&P 500, because of its Beta of 0.09 – has 10% weighting in Pakistan, 20% in Kuwait, and almost 50% in financial stocks
    • iShares Italy ETF (EWI) – 7 of the top 10 holdings get an average 72% of their sales from outside Italy
  • I fear that these examples from the edge might have been too easily ignored or forgotten precisely because they focused on more marginal sectors of the market. So, in this letter, we’ll go mainstream and see what’s going on in the most basic portfolio building blocks, the bread and butter asset classes: first, the S&P 500 itself and then a typical mainstream growth fund and a mainstream value fund

The Broad Market – The Active and Passive Camps Agree

  • Vanguard Group founder Jack Bogle: true believer in equities yet, even he publicly cautions that if they’re looking forward 10 years, investors should no longer expect more than about 4% from stocks. We’re in general agreement, but perhaps less optimistic
  • Problem #1: Valuation
    • Using the broadest and most straightforward measures, market is a hair’s breadth away from historically peak valuations, the aftermaths of which were disastrous
    • Current P/E and average P/E ratio: S&P 500 now trades at 23.4x LTM reported earnings; paying almost 24 years’ worth of earnings for a basket of mega businesses is understood to be really high, but this level has often been exceeded due to the significant variability in reported earnings in any given year
    • Approach preferred by many economists and investment strategists uses price relative to average earnings of the prior 5 or 10 years in order to smooth out temporary and episodic noise; by this measure, S&P 500 trades at 29x earnings which has been exceeded only twice before in the past 130+ years (in 2000 and in 1929)
    • Total market cap-to-GDP ratio: more understandable and less arguable than P/E is this measure; combined market value of all US stocks is now near the 2nd highest on record: at 125% of GDP as of October 2016
    • Today, just over 17 years after the Internet Bubble peak in 2000 and after an 8-year bull market, SPDR S&P 500 ETF returned 2.7% – even this result only pertains if everybody stayed in, which they didn’t (turnover of SPY is 1,900% a year, or 100% every three weeks)
      • Credit Suisse says published return of SPY over the past 10 years might have been 7%, but because of people putting money in following market appreciation and taking it out following market declines, return was more like 3.5%
    • Problem #2: Age – Of the Index, That Is
      • Growth profile and earnings power of the S&P 500 and other large-cap indexes has changed – it is no longer what it once was and the historical result cannot be replicated
        • Future growth from the top of the index: money flows of mass market indexation have created structurally automatic bids for the major index companies; particularly the branded consumer products businesses like Coca-Cola and P&G are mature and generally have stagnant or declining revenues which represent the great bulk of the value of S&P 500
        • Future growth from the bottom of the index: Historically, smaller companies represented the future growth. While their early weighting and market caps were small, they were sufficiently large relative to the balance of the index that they could have meaningful impact on the index return. Today, the high weightings of the mature companies are largely fixed and their presence suppresses the growth from the bottom of the index

A Visit With A Mainstream Value Manager and Growth Manager

  • Let’s take a look at one value oriented and one growth oriented funds, each of which draws its holdings from within the S&P 500 – the managers simply select the cheaper stocks on the one hand and the higher-growth stock on the other
  • Companies in the value fund trade at 18x LTM earnings and 2x book value: whether one thinks this is expensive for a value fund or not, it is cheaper to the growth fund P/E of 23.7x and P/B of 5.0x
  • In the Value Fund, 26.48% is in Financials – Financials are typically cheaper than the rest of the stock market (they are highly leveraged); is 26.48% alarmingly high?
    • Current weight of Financials in S&P 500 is 14.2%
    • Highest weight this sector ever recorded was at the end of 2006 on the eve of the Financial Crisis when the weight was 22.27%
  • The Growth Fund’s largest sector is Information Technology at 34.53%; is this low, average, or high?
    • Current S&P 500 weighting is 21.99%
    • In March 2000, at the white-hot finale of the Internet Bubble, IT was 34.81% of the S&P 500
    • Amazon has a 3.2% weight in the Growth Fund but is categorized under Consumer despite having Amazon Web Services which is by far the largest cloud computing and storage company, ahead of MSFT, IBM, and Google
  • Question is: Would you, or should you, dismiss one or both of these value and growth managers? Would you even own such a fund, knowing their financial and tech sector weightings?
    • Value Fund is actually the iShares S&P 500 Value ETF (IVE) and Growth Fund is actually the iShares S&P 500 Growth ETF (IVW)
  • Returns for each of these two ETFs for the past 5 years don’t differ from each other and hardly differ from the S&P 500 ETF itself: 14.59% 14.48%, and 14.33%
    • iShares Russell 2000 ETF earned 14.51%
  • Value ETF has 353 holdings while the Growth ETF has 321 names – how is it possible to divide the S&P 500 along the fault line of P/B value and emerge with 2 funds that collectively hold 674 names?
    • Contrary to the assumption that each index is defined by the division between high and low valuation multiples, they’re actually differentiated not by security, but by the weights assigned to different sectors
  • To miss this is to miss what’s behind the entire ETF phenomenon and the absurd and dangerous fund structures being placed into asset allocation programs and robo-advisor apps – it’s about the business of asset gathering and the ETF price war
  • The challenge to rational practice of indexation is the profit motive – index funds are, by definition, commoditized products and it is wholly rational that the for-profit companies that promote index funds try to avoid selling near-zero-fee products
    • The use of marketing to promote the sense of product differentiation to the customer in order to secure a higher price is not new
    • ETF industry has hijacked traditional indexation and distorted it to a dangerous degree: one cannot even be sure that when one buys a country fund, one even gets that country

The Unavailability of Alternative Asset Classes/Sectors

  • Because of $1+ trillion that flowed into ETFs since the Financial Crisis, in practical terms, ETF organizers could only accommodate this magnitude of demand with stocks that have substantial trading liquidity
    • They necessarily promoted large-cap indexes; accordingly, over 80% of stock market is invested in large-cap stocks; only 4.6% of stock market are companies less than $2B in size – they simply cannot absorb a sufficient portion of the equity pool
  • Real estate, perhaps the largest industry in the US, should be an alternative, at least in principle
    • Yet, publicly traded real estate is only 4.1% of the market
    • Moreover, publicly traded real estate trades near all-time high valuations
  • Accordingly, investing must now take place outside of the indexation sphere of focus – while that can’t take place for the majority of investors, it can for a small minority
Image Source: Bloomberg
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