With this commentary, we plan to communicate with you every month about our thoughts on the markets, some snap-shots of metrics, a section on behavioural investing and finally an update on some of the people at MacNicol & Associates Asset Management (MAAM). I hope you enjoy this information, and it allows you to better understand what we see going on in the market place.
“Go for a business that any idiot can run – because sooner or later, any idiot probably is going to run it.” – Peter Lynch
Market Commentary: Active versus Passive Management
Active versus passive management, or which is better for individual investors, is perhaps the most contentious debate in the investment management industry. As an aside, active management simply refers to a manager who operates a unique strategy and shuffles investment positions on behalf of their clients, whereas passive management involves investing in indexed or mutual fund products which simply track the performance of a single sector or index. Active management should not be confused with over-active trading, which is discussed in the behavioural section on the next page.
Due to the strong performance of the major equity markets over the past few years, investors have begun to allocate record amounts of capital to passive investments such as Vanguard Group. Fund-research firm Morningstar reported that, during 2014, investors pulled $12.7 billion from actively managed stock funds and managers, while flowing $244 billion into passively managed funds. The main reasons investors have seemingly shifted in this manner are due to a loss of confidence in active management’s ability to out-perform the indices, the recently strong performance of passive funds, and the simplicity of passive investing.
That being said, retail investors are notoriously late to participate in trends, and we believe that this is another example of such a situation. Passively managed funds have performed well in the recent bull market, however, there are many factors moving forward which we believe will shift out-performance back towards active management.
- Passive funds are often poorly diversified and over-exposed to certain sectors; such funds will only sell a stock if it is removed from the underlying index or no longer fits the strategy it wishes to follow. This leaves passive funds exposed to larger volatility. Active managers are able to provide ample diversification in order to limit this risk.
- Passive funds tend to under-perform when markets tread sideways. During 2000 – 2008, when markets traded sideways, nearly two-thirds of actively managed funds beat the S&P 500. With extended valuations and unimpressive economic growth, we believe that there is a decent chance of sideways stock markets in the near term, where active managers will add value. This is also true for bear markets, where, over the last 10-15 years, the index has only out-performed approximately 35% of active management competitors during bear markets.
- Active managers have many more ways in which to protect against volatility. They are more selective in regards to which investments they choose for client accounts, and are able to trim positions as valuations rise.
There are certainly times when passively managed funds out-perform active managers; however, most of these scenarios involve environments where everything is going right for the stock market and economy as a whole. Passive funds do nothing to protect investors during uncertain environments, which we believe is the current case. With high valuations and questionable economic data, there is a decent amount of risk in the system, and the need for diversification and risk protection is high. In order to protect our client’s capital, we focus on our previously described ‘barbell portfolio’ strategy. To review, this strategy focuses on forming a portfolio around a strong foundation of ‘low-risk’ value stocks, and supplementing those names with various high growth equities with promising future prospects. To complete the portfolio and provide further diversification, we utilize our MacNicol Alternative Trust, which holds various assets that are uncorrelated to the public markets. In Jack Schwager’s book ‘Hedge Fund Market Wizards’, which will be discussed further in the behavioural section, famous hedge fund manager Ray Dalio notes that, by adding assets to your portfolio which are uncorrelated to the public markets, managers are able to achieve returns which are superior on a risk-adjusted basis by a ratio of almost 5-to-1. We could not agree with Mr. Dalio more, and believe that such allocations are a perfect example of how active managers will be able to add value and out-perform on behalf of their clients moving forward in this uncertain environment.
Behavioural Investing: Trading versus Investing
Recently, through our morning perusal of Jeffrey Saut’s (Raymond James) ‘Morning Tack’, we were made aware of a particular quote from legendary Hedge Fund manager Ray Dalio, discussing the difficulty of trading.
“In trading you have to be defensive and aggressive at the same time. If you are not aggressive, you’re not going to make money, and if you’re not defensive, you are not going to keep money.”
We believe that this quote aptly summarizes the paradox of over-active trading, as well as why we prefer to remain long-term investors rather than ‘traders’. Traders make profits off of short term market fluctuations; investors make long-term profits through investing in strong companies and long-term growth trends. Due to the fact that their livelihood depends on the short term, traders are necessarily over-active, which leaves much more room for error. This quote was taken from Jack Schwager’s book “Hedge Fund Market Wizards”, where the author interviews a number of extremely successful money managers. Through further examination of the interview, another insightful quote was found.
“… to the extent that there is strong disagreement about an issue, a lot of the people must be wrong. Yet most of them are totally confident they are right.”
The proliferation and diversity of global opinions on the stock market contributes to daily fluctuations of prices, sometimes for illogical reasons; thus, creating short term price activity which is difficult to predict. In the long-term, however, both individual investments and equity markets will trend in a manner related to the prevailing economic market and influential long-term trends. Therefore, it is our belief that long-term investing is much less reliant on chance and also much more reliable. The comic below is a humorous illustration of how illogical the stock market can be, as well as the effect that over-active traders will have on the market.
It has been a while since I have communicated about myself in this personal section. After a very long winter, I am happy that much better weather is here.
In April I attended a Grant’s conference held at the Plaza Hotel in New York City. I always love getting away to these conferences and learning more about the markets from other’s perspectives. There were some excellent speakers this year – David Einhorn, Bill Gross, David Abrams, John Bogle and Paul Singer to name a few. I managed to connect with Bill Gross during a break and have a direct conversation with the “King of the Bond Market”. Paul Singer (one of the handful of people who saw the credit crisis coming) gave an excellent overview of the markets – especially the bond markets. I decided to sit in the front row to allow my aging eyes a better view of the slides and speakers. This worked out well as I ended up sitting next to Jim Grant, who was hosting the conference.
All three of our kids are well and keeping busy. David, our eldest, is finishing his first year of work after graduation at an investment firm. Sarah has recently graduated with a Business Degree also from the Richard Ivey School at Western and is currently traveling in South East Asia until the end of June. Once she gets back, she will be looking for a job, most likely in the financial sector. Ben has finished his second year at Western University and is running his own business for the second Summer up North doing maintenance. He hopes to get into the Business School at Western while completing a dual degree in Urban Planning. Ben also recently secured an exchange program for next Summer at Bond University in Australia where he will be furthering his knowledge in Urban Planning. He managed to arrange this on a full scholarship including travel expenses.
It looks like all five of us may well be Western graduates after Ben finishes. What a fantastic school!
Last but definitely not least, Diane has been keeping herself very busy splitting her time between the office and our home. She is looking forward to heading up North for the Summer.
David A. MacNicol, B.Eng.Sci., CIM, FCSI
MacNicol & Associates Asset Management Inc.