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Howard Marks: Passive Investing, Quantitative Investing, Impact on Investing

Passive Investing and ETFs

  • Merits of index investing are obvious: reduced management fees, minimal trading and related market impact and expenses, and avoidance of human error
  • Thus index investing is a “can’t lose” strategy; of course, it’s also a “can’t win” strategy
  • Empirical evidence of assets continuing to flow to passive management suggests that many active managers are still falling short of the indices
  • Passive investing has grown to include not just index funds and index ETFs but also “smart beta” ETFs that invest according to portfolio construction rules
  • But what does passive mean when a vehicle’s focus is defined so narrowly? Each deviation from the broad indices introduces definitional issues and non-passive, discretionary decisions
  • Is it a good idea to invest with absolutely no regard for company fundamentals, security prices or portfolio weightings? Certainly not. But passive investing dispenses with this concern by counting on active investors to perform those functions
    • The wisdom of passive investing stems from the belief that the efforts of active investors cause assets to be fairly priced – that’s why there are no bargains to find
    • In short, in the world view that gave rise to index and passive investing, active investors do the heavy lifting of security analysis and pricing, and passive investors freeload by holding portfolios determined entirely by the active investors’ decisions
  • The irony is that it’s active investors – so derided by the passive investing crowd – who set the prices that index investors pay for stocks and bonds, and thus who establish the market capitalizations that determine the index weightings of securities that index funds emulate
    • If active investors are so devoid of insight, does it really make sense for passive investors to follow their dictates?
  • What happens when the majority of equity investment comes to be managed passively? Then prices will be freer to diverge from “fair” and bargains should become more commonplace
  • Right now, about 40% of all equity mutual fund capital is invested passively; most money is still managed actively, meaning a lot of price discovery is still taking place
  • In the current upcycle, over-weighted, liquid, large-cap stocks have benefitted from forced buying on the part of passive vehicles, which don’t have the option to refrain from buying a stock just because its overpriced
    • Appreciation that was driven by passive buying is likely to eventually turn out to be rotational, not perpetual
  • One of these days, investors may want to execute a trade that wouldn’t be doable in the “real” high yield bond market, and may find that it can’t be done via ETFs either. In short, building a strategy around the assumption that ETFs can always be counted on to quickly get you into or out of an illiquid market at a fair price seems unrealistic

Quantitative Investing

  • The process for systematic factor investing goes like this:
    • Manager conducts an examination of a period in history, which shows that superior returns were associated with certain “factors”
    • Manager instructs its computer to search for securities that offer the most of those factors for the money
    • Manager tells the computer in what proportion to weight the search criteria, and the computer proceeds systematically to populate the portfolio with securities that deliver the optimal mix of the factors
    • Computer is instructed to assess the attendant risk. The portfolio is optimized, constraining even the most attractive components in order to limit the representation of individual stocks and perhaps industries, as well as the risk introduced by likely correlations among the stocks. The portfolio is formulaically derived according to the rules, usually without human intervention
  • Other main form of quantitative investing is “statistical arbitrage” or “stat arb”:
    • Let’s assume an investor wants to buy 100,000 shares of XYZ and the market for the stock is “one cent wide” at $20.00/$20.01. Perhaps 5,000 shares are bid for at $20.00 and 8,000 shares are offered at $20.01. The broker takes the 8,000 shares offered at $20.01. The next offering is 6,000 shares at $20.02 and the broker takes those. Then a seller offers 5,000 shares at $20.03, and the broker takes those as well. This buying may move the market to $20.03/20.04
    • A quant’s computer takes note of the fact that the market has moved up and stock has been bought at progressively higher prices
    • If other stocks haven’t moved in similar fashion, the computer concludes that these events are “idiosyncratic” – related to that one stock – rather than “systematic”, or present throughout the market
    • If that stock’s price has moved up idiosyncratically and there’s no news from the company to explain it, the computer concludes the price move took place because of investor buying, not fundamental developments
    • The computer considers the price move a short-term dislocation that resulted from the broker’s efforts to fill the investor’s order
    • It also decides on the basis of the trading to date, the current market, and the status of the order book that buying for that purpose is likely to continue to take place at prices above where the stock would be in the absence of that buying
    • Thus the computer decides the quant should “short” stock to the buyer who’s elevating its price, on the assumption that the quant will be able to cover later, when the buying has stopped and the price has receded. It might be possible to sell stock today at $20.03 or $20.04 that can be bought back at $20.00 or $20.01 in a few days
    • Thus the quant provides liquidity that otherwise wouldn’t exist and is willing to carry positions overnight. In exchange the quant gets a couple pennies more for the stock he supplies than he’ll have to pay to buy it back
  • Stat arb computer responds to disequilibria between the price of one stock and the prices of other stocks or the market as a whole, and it acts on the assumption that the relationship will revert to normal
  • This is like what Long-Term Capital Management did in the late 1990s, looking for statistical divergences that could be arbitraged
    • In 1998, LTCM’s enormously levered portfolio encountered an improbably long period in which, rather than converging, the relationships diverged further
    • Mark-to-market losses caused LTCM’s lenders to require the posting of additional capital; unable to do so, the fund melted down
  • Among the lessons learned in the LTCM experience were that (a) the opportunities for stat arb are limited in size, (b) the capital directed as it must likewise be limited, (c) the leverage employed must be reasonable in order for the investor to survive those periods when historic relationships and probabilities fail to hold, and (d) likewise, it’s important to appropriately hedge out the market’s overall directional risk
  • Quantitative investors program their computers to emulate behavior that was profitable in the past or that is expected to be profitable in the future. The key question is whether, in a competitive, dynamic and interconnected arena like investing, the route to profitability can be captured in a formula, and whether changes in the investment environment won’t negate the formula’s effectiveness
  • Constant renewal – not a formula alone – seems to be a minimum requirement for any quants’ long-term success

The Impact on Investing

  • Index and passive investing:
    • Most people can’t and don’t beat the market, especially in markets that are more-efficient
    • Active management introduces considerations such as management fees; commissions and market impact associated with trading; and the human error that often leads investors to buy and sell more at the wrong time than at the right time
    • The only aspect of active management with potential to offset the above negatives is alpha, or personal skill. However, relatively few people have much of it
    • Large numbers of active managers fail to beat the market and justify their fees. This isn’t just my conclusion: if it weren’t so, capital wouldn’t be flowing from active funds to passive funds as it has been
    • For decades active managers have charged fees as if they earned them. Thus the profitability of many parts of the active investment management industry has been without reference to whether it added value for clients
    • Trend toward passive investing hasn’t occurred because the returns there have been great. It’s because the results from active management have been poor, or at least not good enough to justify the fee charged
    • Trend toward passive investing is likely to continue; at the very least, it reduces or eliminates management fees, trading costs, overtrading and human error: not a bad combination
  • Quantitative investing:
    • Computers can do more than the vast majority of investors, and do it better
    • The supply of “nickels and dimes” is limited to the extent of those disequilibria, and thus only a limited amount of capital can be run this way to great advantage
    • There has to be a reason why the best quant firm – Renaissance Technologies – has returned all outside capital from its flagship Medallion Fund; if an investment approach is infinitely scalable, by definition it’s never economic to limit the capital under management
    • Computers can do an unmatched job dealing with the things that can be counted: things that are quantitative and objective. But many other things – qualitative, subjective things – count for a great deal, and I doubt computers can do what the very best investors do
    • Quantitative investing’s emphasis on profiting from short-term dislocations leaves a lot more to be mined. So much of investing these days considers only the short run that I think there’s great scope for superior active investors to make value-additive decisions concerning the long run
    • Computers, AI and big data will help investors know more and make better quantitative decisions. But until computers have creativity, taste, discernment and judgment, I think there’ll be a role for investors with alpha

Oaktree Howard Marks’ Memo: Investing Without People, June 18, 2018

Howard Marks, CFA, is the Co-Chairman of Oaktree Capital, an alternative investment management firm he co-founded in 1995.

Image Source: Bloomberg

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