“The trend is your friend.” I don’t know if you’ve heard that expression before or not, but it is a well-known wall street axiom. Well the trend may be your friend on the way up, but as history has shown us again and again, the trend is NOT your friend on the way down! Momentum investing advances move like an escalator, with a deliberate and powerful movement up. Momentum investing on the way down resembles an elevator! Indexing is a natural partner for this style of investing.
What is indexing?
In 1973 Burton G. Malkiel wrote the seminal research book “A Random Walk Down Wall Street.” In this book Malkiel posits that a monkey throwing darts at a table of stocks can perform as well as any investment professional. The key to successful investing, he claims, is low cost diversification. John Bogle of Vanguard group popularized this strategy with the vanguard S&P 500 index fund. How popular is this strategy you ask? Today index funds account for 43% of all stock fund assets, and are expected to reach 50% in the next three years. Over $7 trillion is currently not actively managed. In fact, there are more than 5000 indices and just 3485 stocks!
This approach has recently been applied to even lower cost exchange traded funds or ETFs. This indexing philosophy believes that no research on companies is necessary because it is impossible to know which companies will perform best in the future. Prices don’t matter, only diversification does. The irony is, because the S&P 500 is a market cap weighted index, the better large companies (Google, Netflix, Amazon, Apple) perform, the greater their percentage in the index and the less diversification index investors receive. For example, Microsoft makes up 3.2% of the S&P 500 index. The world’s largest retail store (Walmart) is 0.5%.
Why is this happening?
There is a trend among financial advisors to move toward a fee based RIA model, and away from a broker commission based model. This places an emphasis on the fees clients are paying. Low cost ETFs are allowing some RIA’s to increase their fees while keeping the fees that clients pay the same. Financial advisors and hedge fund managers are also using these ETFs as tactical vehicles. The turnover rate (or the percentage of a holding that is bought and/or sold in any given year) in ETFs is 785% versus 144% in the stocks themselves. Actively managed mutual funds, on the other hand, generally have much lower turnover rates. Most consider themselves buy and hold investors vs. traders. They also charge more to research the companies they choose to invest with.
How does this end?
Since the financial crisis ended with a stock market bottom in March 2009, momentum or index style of money management has outperformed active or value investing. That may change soon. In fact, over the past 12 months’ passive index funds have attracted $573 billion compared to active ‘s $30 billion through the first quarter according to Morningstar Direct. When money moves into passive ETFs, the demand exceeds supply causing prices to rise. These rising prices attract more money and that leads to better performance. Rinse and repeat.
The idea that I should own a company simply because it exists and has been included in an index belittles the concept of knowing what you are buying. Who would ever buy a new car (or a used one for that matter) simply because it is made? Wouldn’t you want to kick the tires first? Take it for a test drive? Or at least see a picture of it? This market reminds me of the late 1990’s when momentum investing went into tech heavy funds. Of course that ended badly. After peaking at just over 5039 on March 10, 2000, the NASDAQ declined to 1169 on September 24, 2002. If you invested in the NASDAQ at the March 2000 high, your return from September 24, 2002 just to break even would have to be 431%!
Well as a wise man once said, “history may not repeat itself, but it often rhymes.” Good old fashioned value investing paid off handsomely in the years 2000-2002. Is that history I hear rhyming?