So the other day, Goldman “uncovered” something interesting.
I use the scare quotes there because what the bank found when they looked at the relationship between efficiency and index weight in the S&P was hardly surprising.
But just because it wasn’t surprising doesn’t mean it wasn’t worth mentioning because apparently, a whole hell of a lot of people don’t understand it, otherwise they wouldn’t be pouring money into ETFs that mindlessly replicate benchmarks.
Recall what Goldman found when the compared a simple measure of capital allocation to index weight:
With the runaway growth of these products we ask if following an index is the optimal allocation for capital.Namely we run an analysis juxtaposing the ROIC v WACC of the S&P 500 by weights of the underlying stocks. We find that it is not.
There appears to be no direct relationship between a company’s ROIC/WACC and its weight in the S&P 500..
ROIC / WACC for the top 10 companies in the S&P 500 (20% of the index), on average, is lower than that of the next 70 companies.
So that’s actually even worse than Goldman made it sound. Why? Because it suggests that ETFs are promoting the gross misallocation of capital on two levels. First, these vehicles are causing investors to misallocate their own capital by funneling it disproportionately to companies that are (relatively) poor capital allocators. And second, it invariably creates perverse incentives for the companies in question as they can cross “efficiency” off the list of things they need to be concerned about when attracting investor dollars.
Well if ever there was a great setup for the following commentary from Bloomberg’s Cameron Crise, surely that’s it.
Read below as Crise explains “the real reason active managers are struggling.”
The relationship between active equity managers and the stock market has been a fractious one in recent years, thanks to chronic performance issues. As alpha has declined, the correlation to benchmark indices has risen dramatically. If the market could talk, however, it might say to frustrated stock pickers, “It’s not you, it’s me.”
- Using the EQS function, I set up a couple of simple screens to capture alpha on both the growth and value vectors. The results were illuminating.
- To capture growth, I set up a simple screen for stocks with compunded annual revenue growth of at least 25% and a return on invested capital of at least 15%. I then ran a backtest going back to 1993. The most revealing outcome was not the performance (which actually tests pretty well), but the number of stocks that fulfill the criteria over time.
- In the mid-to-late 90’s, there were often more than 100 stocks that met my criteria. By the end of last year that had fallen to 32. Any risk-taker will tell you that the more independent opportunities that you have to exploit an edge, the greater the chances of ultimate success.
- In fact, the correlation between the number of stocks fulfilling the simple growth criteria and the 5-year returns of equity hedge funds is 0.77.
- I also set up a value screen, looking for stocks with a P/E below 15, a price to book ratio below 1.5, a current ratio above 1.5, and 5 year EPS growth of at least 5% (to avoid the dreaded “value trap.”)
- The correlation between the number of value opportunities and hedge fund returns is much more tenuous, notably because the number of value stocks tends to rise when stock markets (and manager returns) go down. Still, it is worth noting that the value screen returned as many as 285 opportunities in early 2009, but yields just 32 today.
- What is extraordinary is that even as the number of stocks in my growth and value baskets have declined since the heyday of active and equity hedge fund management, the correlations of these strategies to the S&P 500 has risen. Indeed, plotting these basket correlations makes it pretty clear why hedge fund and active investors’ correlations to the index have gone up so much.
- All of this is, of course, descriptive. Finding a remedy to active managers’ woes is more challenging than simply saying “don’t hug the benchmark.” The strategies illustrated above take no view on the portfolio beta to the S&P 500 and maintain a consistent methodology over time, yet have still seen opportunities (and returns) go down and index correlations rise.
- It may be the case that there is simply too much money chasing too few opportunities these days, and that the efficient-market folks are right. I suspect, however, that there are still factors out there to exploit and increase the opportunity set. That the correlation of the growth screen in particular has started to decline is reason for optimism.
- It’s going to take more than a few hours of work with an equity screen tool to find them, though. In the meantime, active managers might need a bit of therapy to restore their relationship with the market.