Up until recently it had been salad days for investors using passive ETFs to invest overseas. The S&P 500 index, which weights the largest 500 companies listed in the US by market value, has increased 183 per cent since the low in March 2009. When you’re earning around 16 per cent per year, why bother with hedge funds and other active managers, many of which are failing to keep up with the market?
Last year was awful for many of the world’s renowned value investors. Seth Klarman’s Baupost Group suffered only its third down year in decades. David Einhorn’s Greenlight Reinsurance fell 20 per cent, and even Berkshire Hathaway offered no protection, falling 12 per cent.
Given the high fees most of these investors charge, it’s yet another reason a tidal wave of money has poured into passive investment strategies, such as ETFs. In 2015 alone the growth in passive ETF funds under management was reportedly US$347 billion. Meanwhile, barely a week goes by without another active manager closing its doors.
Passive ETFs have served investors well since the GFC. Returns have been strong, up until recently there hasn’t been much volatility since late 2011 when the European Union threatened to tear apart, fees have remained low (or are falling further) and exposure to the most popular technology stocks (Facebook, Amazon, Netflix and Google [now Alphabet] – the FANG stocks) has been a boon for investors, in contrast to those exposed to managers chasing bargains in the bloodied energy sector or other out-of-favour industries.
Wise in the beginning, fools in the end
But “what the wise do in the beginning”, warns Warren Buffett, “fools do in the end”. Passive ETFs have become so popular that they’re potentially becoming victims of their own success. The FANG stocks increased 88 per cent on average in 2015, and as more money flowed into ETFs more money chased these high performers, which lights even more rocket fuel under their share prices.
This momentum then attracts more investors paying scant regard to valuations. Facebook’s price-to-earnings multiple is over 100, Amazon’s is 1000, as it’s just turning profitable, Netflix’s is over 300 and Alphabet’s is over 30. Murray Stahl, chief investment officer of Horizon Kinetics, provides perspective.
“Netflix [is] a partial demonstration of a preposterous phenomenon, preposterous because even if the analysts’ maniacally optimistic earnings projections are actually realized (the 35 analysts who cover Netflix anticipate a 5-year earnings growth rate of 24 per cent) and even extend that to 6 years, the application of a 30× P/E ratio in 2021 would result in a loss of 80 per cent.”
Passive ETFs were also blamed for accentuating the mini market crash in August 2015, when the S&P 500 fell 10 per cent within a week. Some ETFs opened down 35 per cent, despite the underlying holdings not falling anywhere near as much. Due to their short histories, how they’ll perform in a genuine crisis remains to be seen.
Stomach to handle downturns
If you’re a genuine long-term investor with modest expectations and the stomach to handle major downturns, then passive ETFs may be suitable for your portfolio. But in a market where value is not the overriding concern, it’s vital to consider what sort of returns a passive ETF might provide given current valuations.
The reason passive ETFs have worked so well since the GFC is because the market was almost two-thirds lower than it is today. Not only do current valuations compare with those just prior to the Great Depression and the tech boom that produced the tech wreck, but current profit margins are at record levels too.
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Lofty expectations fall to earth
Low interest rates have severely reduced borrowing costs, companies have cut costs dramatically and wage growth has been almost non-existent. It’s easy to see how some stocks could easily lose half their value or more when today’s lofty expectations fall back to earth.
If ever there was such a thing, the easy money since the GFC has been made. I’d happily bet that the group of active value investors mentioned above will eventually bounce back, but not by buying passive ETFs. Instead, they’ll follow the tried and true method of opportunistically buying undervalued, high-quality businesses with bright prospects to build outperforming portfolios without taking excessive risks. I’m much less certain that today’s passive ETF investors will be satisfied with their returns over the next five to ten years.
