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What We’re Reading This Week

Stocks are Dangerous

Lately it seems like everyone has something negative to say about ETFs. They are either promoting monopolies or Marxism. Larry Swedroe at ETF.com doesn’t think so…obviously. I mean, I wouldn’t expect someone at ETF.com to have negative things to say about ETFs. Still, it’s an interesting read. He explores a new study from Longboard. Longboard is an asset management company so it’s also safe to say they are all for professional management.

According to the research, from 1989 through 2015, “The S&P 500 Index returned 10.0% and provided a cumulative return of 1,324%. The broader Russell 3000 Index produced almost identical results. It returned 10.1% per year and provided a cumulative return of 1,341%.”

Additionally, only “1,120 stocks (7.7% of all active stocks) outperformed the S&P 500 Index by at least 500% during their lifetimes.” And, “6,398 stocks (44% of all active stocks) lost money, even before considering inflation.”

Essentially, that data shows that 20% of the market makes up the cumulative return of the S&P over that time period. The thesis is that investors need to diversify and be smart about it.

On its surface, the argument makes sense. However, I have to imagine that of the 14,500 stocks analyzed, some of them are less important than others. There must be a lot of companies that no one was really interested in buying in the first place. Also, just like there are some major growth stocks driving the upward returns, there must be some huge failures on that list too. Consider the dot-com bubble in the late 90s. Webvan went public in 1999 and doubled its return on the first day and promptly went bankrupt in 2001. Pets.com had its IPO in 2000 and filed for bankruptcy 300 days later.

My point here is only this: the data can be skewed to show anything you want. If you want stocks to look terrible, you can show that. If you want diversified funds to look great, you can show that. One thing remains, if you want index-like returns, you can buy the index.

In Defense of Index Funds

Morningstar continued the trend of defending index funds here and here. Instead of leveling the accusation of Marxism, they broke index funds crimes into three categories:

1) Index funds have inflated the stock market.

2) Index funds have distorted how equities are priced, by bloating the shares of companies that are in the popular indexes, and neglecting the shares that are not.

3) Index funds harm the process of corporate governance.

The first one is sort of a layup, right? How can an index fund inflate the market? If someone buys Ford on the market or buys an index that owns Ford, who cares? I guess one person cares, the active fund manager that buys Ford. But the market doesn’t care. Demand is demand. The market is investor neutral.

Number two is a little more complex but I like it. The article makes the argument that market mispricing is diluted by diffusion. Meaning, while some stocks may not get included in an index, they are surely picked up in other index. For example, “Over the past five years, Standard & Poor’s MidCap 400 Index has gained 14.3% annually, while the S&P 500 is up an almost-identical 14.4%.”

The third claim gets its own article and is a fairly interesting read. They are essentially assessing corporate governance by measuring shareholder value. Is shareholder value too low? The core of this argument is that index funds won’t penalize CEOs like active fund managers or activist investors. Ostensibly, as index funds become more prolific, CEOs would become progressively worse at their jobs. Maybe there is some latent data that needs to be analyzed, but so far the evidence doesn’t really support that.

Alternatively, is shareholder value too high? This one makes more sense to me, at least on the surface. The core argument is that index funds reduce competition and increase shareholder prices because companies are incentivized to play nice with one another. Yes, investors make more money but there is a societal impact. Essentially, they are talking about collusion-like outcomes. The good people at Morningstar don’t think this pans out. However, out of all of the problems people have with mutual funds, to me, this one makes the most sense.

The News

Elsewhere in the world, the Columbia Business School is figuring out how to predict the stock market based on the news.

The school’s research found that “Articles that contain words with pre-identified positive sentiment value are associated with positive returns, while those with negative value are associated with negative returns.” Good work guys? Interestingly, they also found that “unusual” word strings can help potentiate the article’s impact. So, saying positive things, in a weird way, will drive higher returns than saying it normally. I guess that makes sense. If you say something everyone has heard before but in a new way maybe that counts as new information.

The trouble I have with this type of research is the same problem I have with quant-type research. First, once all the computers are measuring all the data, we will all get the same market returns. Also, measuring things inherently changes the outcomes. Using the news, or any other piece of data, only helps you achieve better market returns when you are the only one doing it. Eventually, we have to measure new and stranger data to stay ahead of the curve. This line of thinking leads to, well, doing what these guys are going. Once you start reaching for predictive market analytics you are a short journey away from recording CEO tie colors during the work week. Correlation does not equal causation.

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Categories: Industry Ideas, News, The Market