GavekalResearch The Daily

December 20, 2019

Page 1

Active Versus Passive

Charles Gave
cgave@gavekal.com
Three false nostrums lay behind the
bubble of the mid-naughties
Today, a similar situation is developing
when the performance of active and
passive investments is considered
Back in 2003, low interest rates were creating problems for pension funds
and insurance companies which could not find enough high-quality bonds
offering a decent interest rate. Not to worry, said Wall Street banks, which
began to package up real estate-based bonds of varying quality; the best
tranches got a triple-A stamp from the credit rating agencies, yet they
miraculously offered a higher yield than other top-notch bonds. We all know
how this story ended, yet behind the disaster lay three key factors:
1) A blind belief in computer-driven valuations replaced price discovery.
2) A false price in short rates, coupled with “forward guidance” by central
bankers allowed the build-up of huge carry trades. This created a market
based on a false cost of money and assets with no proper price.
3) A good many money managers really did believe that with the help of a
few computers, a scoring agency could do the job of a real market.
Fast forward to today and what I am learning is that active managers are
underperforming the S&P 500, and said index has outdone 78% of all quoted
equities in the last 12 months, and 66% or so over the last three years.
This means the US benchmark not only beat sentient professionals, but also
outdid the proverbial chimpanzee throwing darts at the share list. This has
me worried because it contradicts the Markowitz theory of randomly acting
share prices in a stock market (a condition that works pretty well in all but
the “tails” of the risk distribution). In theory the S&P 500 should do as well,
but no better, than a similar portfolio built with darts—but it has not.
The following can be deduced from this observation:
1) There is no logical reason why the Standard & Poor’s committee that
selects shares for inclusion in the US equity benchmark should achieve a
better long-term return than a portfolio manager or a monkey with darts.

Checking The Boxes

Our short take on the latest news
Fact
US existing home sales fell
-1.7% MoM in Nov, from 1.5%
in Oct
Swedish Riksbank raised repo
rate to 0% from -0.25%
Japan CPI rose 0.5% YoY in
Nov, up from 0.2% in Oct
Mexico cut benchmark over-
night rate by 25bp to 7.25%
Consensus belief
Lower than -0.4% expected
As expected; Riksbank signaled
it would leave repo rate at 0%
for the "coming years"
As expected; CPI ex-food and
energy rose 0.8% YoY, from 0.7%
As expected
Our reaction
Trend till upward; stimulus from
lower mortgage rates over past
12 months still supportive
Riksbank keen to exit negative
rates; ECB negative rate policy to
face greater scrutiny in 2020
Rise in inflation mostly due to
tax hike; BoJ to remain on hold
as fiscal stimulus takes effect
Weak growth and low inflation
allows room for Banxico to
continue easing cycle

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 GavekalResearch
Investors should protect themselves by
seeking out a portfolio comprised of
shares not in the main benchmarks
Active managers seem to do better in
return-to-the-mean periods; passive
investors do better when momentum-
buying dominates
The Daily
December 20, 2019
Page 2
2) It must be concluded that the benchmark is outperforming not because it
is the best portfolio at any point in time, but simply because it is the index
and, as such, is bought directly by many investors.
3) The benchmark is outperforming not due to some superior intelligence in
index composition, but because more and more money is leaving active
money managers (or the monkeys) to be invested into the index.
4) The implication is that individual shares that make up the index must
inexorably be getting overpriced compared to the shares not in the index.
5) It follows that investors should build a portfolio of shares not in the index
safe in the knowledge that such a long position versus a short against the
S&P 500 will, over time, do just fine.
6) A portfolio of non-index stocks should outperform the official benchmark
over the long term since the ROIC achieved by the companies in both
groupings should be the same. Of course, this assertion does discount
the possibility that the S&P indexing committee knows more about the
outlook of such firms than active money managers.
Yet having been around for a while, I can attest to John Maynard Keynes’s
dictum that the markets can stay irrational longer than most investors can
stay solvent. Hence, I would propose the following as a timing device.
Buying a market capitalization-weighted index like the S&P 500 is really a
systematic way of doing momentum buying; the higher the market cap, the
more the passive investor should buy. Such momentum buying always leads
to an exponential rise, or the “killer wave”. Only when all investable money
in the world has been invested in the index does the crash materialize.
Conversely, an index of the same S&P 500 shares on an equally-weighted
basis is nothing but a portfolio working on a return-to-the-mean principle.
I cannot prove it—not having the required statistics—but active money
managers should do better in a return-to-the-mean period; passive investors
should shine in a momentum-based period. This is because most active
managers have a hard time buying assets that are clearly overvalued; passive
managers have no such fears as computers are brain dead.
Hence, if the ratio between the two S&P 500 indexes (market cap vs equally
weighted) is above its 12-month moving average, my recommendation is to
stay passive. Conversely, if the ratio falls below its 12-month moving average,
investors should go active. Since early 2017, the ratio has favored passive
positions (see chart overleaf). Over the long-term, however, the return-to-
the-mean strategy beats the hell out of momentum, as logic suggests it should.
And so, I find today exactly the same pattern that was present from 2003-07,
but on different supports.
1) No effort to engage in market-based price discovery, with effort being
replaced by computers engaged in a huge case of “free-loading”.
2) Ridiculously low short rates accompanied by massive monetary easing.
3) A belief by market participants that their markets will stay open and trade
continuously. They did not in 2008-2009.
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 GavekalResearch
A key indicator that the next bull market
has started will be big passive funds
applying gates to their vehicles
The Daily
December 20, 2019
Page 3
In the most irrational investing periods, active managers will shed clients and
assets held by passive managers will explode. As we are now experiencing
a pretty irrational time due to central bank money printing/price-keeping
operations, the next bear market will likely start with passive managers being
unable to sell overvalued shares. Such a turn of events will be signaled by
money management firms raising the gates on their largest passive funds.
To prevent savings from being caught up in such an event, I would take the
precautionary move out of the S&P 500 market cap-weighted index and move
to the the S&P 500 equally-weighted one instead. Once the moving average
has been decisively crossed in my decision rule the markets may be rendered
closed or totally illiquid, and it will be too late to get out.
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