April 9, 2012


Market Commentary April 2012

Equity markets got off to an outstanding start in 2012.  Returns for the first three months represented the best yearly start since 1998, as the S&P 500 was up 12.6%.  As you can see in the chart, equity markets were generally up 11%-13% with emerging markets up 14%.  The broad bond market essentially broke even for the quarter, while riskier bonds, like high-yield corporates, were up as much as 5%.

Equity returns exceeding 10% would be welcome for the year, say nothing of the quarter.  Some fear that we are now due for a correction, as the markets have risen too rapidly.  We try never to predict future market movements, but it is worth noting that the S&P 500 index, ignoring dividends, reached 1530 back in March 2000.  It got back to 1560 in the fall of 2007 before retreating, and it is now hovering around 1400, meaning that the value of the 500 largest U.S. companies is still well below the level first attained twelve years ago, and earnings continue to improve.  So while a correction is always possible, there seems equal opportunity for further upside.

It is also interesting to note how much less volatile markets have been in the last quarter as the debt crisis in Europe generates fewer alarming headlines, and other economic news has taken on a positive tone.  The European debt crisis seems far from solved, and yet just the absence of bad news has had a surprisingly positive effect on global equity markets.

Should Passive Investors Feel Bad About Getting a Free Ride?
The efficient market allows passive investors to get a free ride – market returns at minimal cost while others do the work.  Diligent, hard working analysts and active managers are determining the true value of individual stocks and bonds, and driving prices toward those values in an auction market.  Meanwhile, index funds come along and buy a market basket of securities at the market price without doing the work to determine if the prices are fair.

But What Happens When Everyone Buys the Index?  Who Keeps the Market Efficient?
As a believer in the advantages of index funds, I have been asking these questions since before we started an investment advisory firm in 1991.  By that time, index funds had been available to institutional investors for a few years, but they were just beginning to take off with smaller investors using mutual funds.  The new products allowed us to utilize institutional money management strategies for small investors, and it seemed clear that everyone should adopt the new innovation that allowed anyone to get market returns at low cost.  Alas, not everyone saw the world as we did, and they probably never will.

Nonetheless, we now see growing talk of passive management dominating markets, and having a detrimental effect on market function.  In fact it has become the topic of serious research.

The latest issue of the Financial Analyst Journal includes an article, “How Index Trading Increases Market Vulnerability” (Sullivan and Xiong, March/April 2012).  It reports that, “the authors found that the rise in popularity of index trading – assets invested in index funds reached more than $1 trillion at the end of 2010 – contributes to higher systematic equity market risk.”  The implication is that traders are buying and selling the whole market basket without regard to the merits of individual stocks.  I have seen presentation materials from at least one active manager using this argument to help explain why it has been so difficult for them to outperform the market.

On the other hand, Jack Bogle, the founder of Vanguard often credited as the father of index funds, sees the growth of passive investing as a triumph.  About 25% of mutual fund assets are now invested in index funds.  Also, ETFs (Exchange Traded Funds) which typically track an index but trade throughout the day, now represent about 30% of trade volume in U.S. equity markets, having grown from essentially zero in 12 years.   Appearing at a recent conference, Bogle said that in the last five-plus years, index funds have gained $600 billion in assets, while active managers have lost $400 billion.  He says that investors have to be persuaded by the growing evidence that index funds work.

So, will the dominance of passive investing destroy the free ride?  I am not worried.  I believe there will always be plenty of people willing to pay smart analysts to keep the market efficient.  My latest evidence of this was published in the New York Times on April 1, 2012 in an article entitled, “Public Worker Pensions Find Riskier Funds Fail to Pay Off.”  The article reports on public workers’ pension funds across the country, increasingly turning to riskier investments in private equity, real estate and hedge funds…“but while their fees have soared, their returns have not.”

It goes on to explain that the states using more of these alternative, actively managed investments have incurred higher fees and worse performance, compared to the states that stuck with a more traditional mix of stocks and bonds.  Yet the Oklahoma Teachers Retirement System, which has done well over the past five years with a mix of stocks and bonds, is putting 10 percent of its fund into private equity and real estate funds.  When asked about the higher fees, the fund’s executive director said, “We believe the outperformance from moving into these categories can justify the additional fees,” demonstrating that hope springs eternal, and that Mr. Bogle is an optimist to think that investors will be persuaded by the facts.  I think passive investing has a bright future, and I will be happy to continue taking that free ride.

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