By Philip van Doorn, MarketWatch
What will it mean when ‘everybody’s doing it’?
Another important argument in favor of passive management has been that broad index funds have performed better than most active mutual funds and hedge funds during the seven-year (and counting) bull market. Active managers are taking it on the chin.
Here are some astounding numbers, showing investors’ declining respect for stock pickers. Over the 12-month period through Sept. 30, $184.6 billion flowed into stock index funds, while $236.2 billion flowed out of actively managed equity funds, according to Morningstar’s Asset Flows Commentary . Of course, this not only hurts active managers who may not want to sell assets at a particular time to raise money for redemptions, it also forces some equity funds to merge into others, or to cease operations.
“The ideal world for an active manager that survives, is to have nearly all the other assets invested passively. If the world were 90% passive and 10% active, the active investors would do very well, because they would be able to react to events,” Kaser said.
That should give you pause. Dumping money into an S&P 500 /zigman2/quotes/210599714/realtime SPX -0.30% index fund has been a good recipe for success during the bull market, but could you imagine an extended period of weakness for stocks? If not, you have a short memory. According to research conducted by Timothy McIntosh, the author of “The Snowball Effect: Using Dividend & Interest Reinvestment to Help You Retire on Time,” there were four very long bear markets for the Dow Jones Industrial Average from 1906 through 2011, almost 70% of the time period, as measured by the Dow Jones Industrial Average /zigman2/quotes/210598065/realtime DJIA -0.20% .
“The movement toward passive is very good for active, for the long term. What the tipping point is, nobody knows. We’re not there, but the tipping point does exist,” Kaser said.
Consider the tendency of people to follow trends and fads. Then imagine headlines, 10 or 15 years from now, about money managers who have outperformed the market. It just might happen.
Brandywine’s value approach
Brandywine’s classic large-cap value equity strategy is to “outperform the investment benchmark [the Russell 1000 Value Index] over a three- to five-year period, produce a yield greater than the benchmark and maintain a portfolio with consistent large-cap value characteristics,” according to the portfolio summary . Those value characteristics are typically low price-to-earnings ratios and low price-to-book-value ratios.
Here are average annual net returns (after management fees) for the strategy, as provided by Brandywine (audited by Kreischer Miller of Horsham, Pa.), against those of the Russell 1000 Value Index /zigman2/quotes/210598148/delayed RLV -0.0022% and the S&P 500:
|Total return - 2016 through Sept. 30||Avg. return - 3 years||Avg. return - 5 years||Avg. return - 10 years|
|Brandywine Global’s Large Cap Equity Strategy||4.0%||4.5%||14.3%||6.8%|
|Russell 1000 Value Index||10.0%||9.7%||16.3%||5.9%|
|Source: Brandywine Global Investment Management|
So Brandywine’s large-cap strategy has beaten the Russell 1000 Value index for 10 years, but has underperformed it for all other periods, while trailing the S&P 500 for all the periods shown here.
Despite the underperformance, Brandywine’s managers believe their strategy is a good one for investors seeking not to overpay for stocks. According to the firm, the portfolio’s price-to-earnings ratio, based on the past 12 months, is 12.5, which compares with a trailing price-to-earnings ratio of 18 for the Russell 1000 Value Index. For the S&P 500, the trailing P/E is also 18, according to FactSet.
Investors’ “flight to yield” has been a major story in the financial media this year. Stocks with high dividend yields, mainly in the telecommunications, utilities, real-estate and consumer-staples sectors, have been very strong.
“I would argue that we now have a low-volatility bubble,” Kaser said, adding that the portfolio he manages has only about 3% of its assets in those sectors, compared with about 24% for the Russell 1000.
Here are the top 10 stock holdings in Brandywine’s equity value portfolio, as of Sept. 30:
|Company||Ticker||Share of portfolio||Trailing P/E||Price/ consensus 2017 EPS estimate||Total return - 2016 through Oct. 21||Total return - 5 years|
|Citigroup Inc.||/zigman2/quotes/207741460/composite C||5.0%||10.8||9.6||-4%||11%|
|Bank of America Corp.||/zigman2/quotes/200894270/composite BAC||4.9%||13.9||10.7||0%||22%|
|BP PLC||/zigman2/quotes/207305210/composite BP||4.5%||N/A||15.1||23%||2%|
|Devon Energy Corp.||/zigman2/quotes/209479244/composite DVN||3.5%||N/A||33.3||35%||-6%|
|General Motors Co.||/zigman2/quotes/205226835/composite GM||3.4%||4.1||5.6||-2%||8%|
|Micron Technology Inc.||/zigman2/quotes/205710729/composite MU||3.2%||N/A||14.9||20%||25%|
|J.P. Morgan Chase & Co.||/zigman2/quotes/205971034/composite JPM||3.2%||11.8||11.0||7%||19%|
|KKR & Co. LP||/zigman2/quotes/206126495/composite KKR||3.1%||N/A||7.0||-7%||10%|
|Canadian Natural Resources Ltd.||/zigman2/quotes/203976248/composite CNQ||2.9%||N/A||43.4||57%||2%|
|China Mobile Ltd.||2.7%||13.9||13.5||7%||7%|
|Sources: Brandywine Global Investment Management, FactSet|
When he talks about running “toward the fire,” Kaser means it, as you can see from the five “N/A” entries in the trailing P/E column. If there’s no number there, it means the company has been losing money.
The next column includes forward P/E ratios, based on consensus 2017 earnings estimates. In comparison, the forward P/E for the S&P 500 is 16.2, according to FactSet.
“We see opportunities in big banks, Citigroup Inc. /zigman2/quotes/207741460/composite C -0.06% and Bank of America Corp. /zigman2/quotes/200894270/composite BAC +0.12% in particular, as well as private equity,” Kaser said. For private equity, he gave two examples: KKR & Co. LP /zigman2/quotes/206126495/composite KKR -0.21% and Blackstone Group LP /zigman2/quotes/203156858/composite BX -1.01% .
“People seem to be extrapolating that the downward trend in interest rates will continue or go sideways,” Kaser said, adding that the “real opportunity in financials is that investors generally are putting a very high probability on negative outcomes and a very low probability that things will go better than expected.”
With valuations so low for financials, a better-than-expected environment “will be a very powerful kicker for those stocks to do well,” he said.
The portfolio’s fifth-largest holding is General Motors Co. /zigman2/quotes/205226835/composite GM -0.55% . Once again, Kaser thinks investors are too pessimistic about car sales, since the stocks are priced as ”assuming the auto sales cycle is going to do a repeat of 2008 and 2009, and go down dramatically.”
“So companies like GM or [auto-parts supplier] Magna International Inc. /zigman2/quotes/204433886/composite MGA +0.48% are trading at really less than half of the market multiple, because of that skepticism. If we have a sales plateau or relatively flat for many years, as we saw from 2000 to 2006, instead of a decline, those companies will continue to generate cash, buy back shares and grow earnings,” Kaser said.