BlackRock’s move this week to replace dozens of fund managers and analysts with robotic stock-selection tools reflects a powerful and somewhat puzzling feature of today’s market: No one does stock picking anymore, it’s too crowded.
Yogi Berra’s paradoxical quip about an unfashionably congested restaurant applies to the traditional Wall Street pursuit of selecting the best stocks. And even the world’s largest asset manager, with $5 trillion under its control, is not insulated from the pressure.
Wall Street firms caught in the middle of these movements have been generating pointed research on these trends for institutional clients, as both the “sell side” and the “buy side” see their business models upended by the flow of trillions of dollars in cheap, technology-enabled money that doesn’t need their help.
In a report last week, global strategists at Citi noted that there’s been nearly a trillion dollar worldwide swing from active to passive funds in the past 12 months, according to fund tracking firm EPFR. Some $542 billion entered index funds while $442 billion departed active portfolios.
Long bull markets always tend to show a surge in money willing simply to match the market return at low cost. Yet most investors and advisors also assume we’re in a lower-return world for years to come, which has led to a “profound reassessment of the fee that savers are willing to pay managers to invest their capital in equity markets,” says Citi.
With the average expense ratio of a U.S. equity fund at 0.84 percent a year versus 0.11 percent for index funds, the flow of cost-sensitive dollars toward indexes and pressure on active-fund fees should only continue.
Meantime, strategists at Bank of America Merrill Lynch this month made the case that a shorter-term, quantitative approach, which tends “to rely on access to better, faster and larger stores of data, has attracted trillions of dollars in capital.” These strategies involve combining an ever-growing set of stock-selection factors and signals meant to offer a slight edge in weighting portfolios. BAML says its quantitatively attuned clients use triple the number of factors today than they did 20 years ago, so new information is sniffed out and priced in fast.
So good luck reading the press release, listening to the conference call and plugging in next year’s consensus earnings forecast to beat the machines.
There’s a growing argument that the fashion for owning the index and using quant tools is setting the stage for its own demise, that so many dollars willfully ignoring traditional fundamental analysis and sleuthing will reopen an opportunity for stock pickers.
There might be some level of passive stock ownership that will cause some distortions that a clever investor can exploit, but this is tough to prove. The opportunity for outperformance has most to do with how high correlations are among all stocks.
Citi searched for evidence that indexing lifts correlations, but found little. Stocks’ tendency to move in unison or more on their own seems more connected to whether macro or corporate forces are driving the market. There’s some evidence in recent months of diminished correlations as central-bank influence on prices has ebbed, but this isn’t tied to “dumb index funds.”
Then there’s the “paradox of skill” problem. When index funds gain market share, on average the lesser-skilled fund managers will be displaced, raising the overall skill level of the remaining investors now fighting to wring relative performance from one another.
Enter Michael Mauboussin, head of global financial strategies at Credit Suisse, whose group took a deep dive into why there are only about half as many U.S. publicly traded companies now than 20 years ago (3,600 in 2016 vs. 7,300 in 1996).
Less incentive to go public is the key driver here. The cause: higher regulatory cost of being public and the enormous venture-capital and private-equity industries that keep hundreds of profitable companies out of public hands.
Most of the companies “lost” over the past 20 years were quite small. And this trend probably doesn’t matter much for the average retail investor: If you own an S&P 500 index fund today, you hold a share in about 80 percent of the total U.S. equity market capitalization. In decades past, the S&P has been closer to 75 percent of total market cap — not a crucial difference.
But with the number of Chartered Financial Analysts per globally listed stock up by a factor of 12 in the past 20 years, as Citi highlights, there are now many more rigorously trained number crunchers seeking informational advantage on each company.
Mauboussin shows, too, that today’s U.S. market is on average populated by bigger, more mature companies, with higher profit margins and a greater propensity to return cash to shareholders. That might be good for fundamental stability, but not for market dynamism or for picking tomorrow’s winners and losers.
As he puts it: “Gaining edge in older and well established businesses is likely more difficult than it is in young businesses with uncertain outlooks. In turn, the greater efficiency may be one of the catalysts for the shift that investors are making from active to indexed or rule-based strategies.”
Where do all these daunting trends leave the average individual investor and would-be stock picker?
Hard doesn’t mean impossible. And it’s true that swaths of the market, in the lower reaches of the market-cap spectrum, have lost so much coverage from belt-tightening brokerage research departments that neglected, attractive stocks can be found and tracked from home.
Yet the BofAML folks claim “the most contrarian theme” is to be a “long-term, fundamental investor.”
This means that truly taking a patient approach, using current-day valuations as the main indicator of future market returns and adjusting asset allocations accordingly will give investors the benefit of the market’s multidecade generosity, while the index funds go along for the ride and quants fight over scraps of monthly and annual relative performance.
It might sound boring, but the one advantage the little guy might have left is the ability to take the long view.