A Summary Of Horizon Kinetics’ Arguments Against Indexation (#investing, #theory, #indexing)

Murray Stahl and Steven Bregman of Horizon Kinetics have written an ongoing series examining the theoretical and practical flaws of indexation as an investment strategy. As the series is long and the arguments are many, I’ve decided to try to summarize each of their major essays into a single summary sentence to make the argument easier to follow. All links below come from the “Under the Hood: What’s In Your Index? series:

  1. International Diversification – Bet You Don’t Know How Much You’ve Got, investors seeking diversification with their indexing strategies are ignorant of the fact that almost 30% of the revenues of S&P 500 companies come from outside the US, and many international companies in non-US indexes derive substantial parts of their revenue from the US; therefore political diversification of economic risk is illusory in index allocation strategies
  2. Not Your Grandfather’s S&P, the calculation of the S&P 500 was adjusted for available float (non-inside held shares) beginning in 2005, meaning that much of expectations about its return built on past price performance is no longer analagous because earlier index returns were purely market cap-weighted and thus the index got the full benefit of great, insider-owned growth stories such as Wal-Mart and Microsoft
  3. Your Bond Index – Part of the ETF Bubble; valuation-agnostic institutional investors following a “diversified” asset allocation model use tools such as international bond ETFs to gain exposure, and the liquidity constraints of the underlying issuance create perverse results wherein war-torn, criminally fraudulent and economically unstable foreign regime debt ends up with lower yields than stable, profitable US corporate debt
  4. How to NOT Invest in the Dynamism of Emerging Markets: Through Your Emerging Markets ETF; using India ETFs as an example, it is shown that the concentration of market caps, lack of trading liquidity and concentration of the largest firm’s revenue sources outside the home market imply that one can not reliably get exposure to an emerging market by buying emerging market ETFs, meaning that the “diversification” available with such tools is illusory
  5. How Liquid is YOUR ETF, or What Does This Have to Do With Me?; in a “virtuous circle”, the liquidity of index ETFs has attracted long-term asset allocators whose allocation decisions have created even greater liquidity in the ETF, but the events of August 24th, 2015, show that it’s possible for this circle to operate in reverse, creating sharply-divergent share price performance between an ETF itself and its underlying holdings
  6. The Beta Game – Part I; allocation models favor low-beta strategies (historical price risk relative to broader market) over high-beta strategies, such that high-beta strategies are being allocated out of existence and low-beta strategies are being allocated into a bubble, even when the underlying strategy itself seems to imply higher risk and volatility than the broad market
  7. A New Bubble Indicator; Is One of Your Stocks In a Momentum ETF?; “the appearance of billion-dollar momentum ETFs means that the most expensive stocks are being bid higher, and those that have not done well – that is, their relative momentum has abated, as it ultimately must – are being sold short, so the cheap are being sold cheaper”, “The index universe has become, simply, a big momentum trade. It is the most crowded trade in the history of investing.”
  8. The Beta Game – Part II; when the beta-trade goes in reverse because peak beta-driven demand is reached, index ETFs which are primarily purchased because of their beta will fall in value and funds will flow into contrarian, non-indexed securities which will also have constrained supply (illiquid) resulting in sharper price increases
  9. The Robo-Adviser, Part I: What Does Rebalancing Mean to You?; asset allocation patterns, especially the robo advisor-driven variety, create a structural need for outsize turnover volumes of ETFs versus the turnover of their underlying stocks as portfolios are more aggressively rebalanced, in the future a cascading rebalancing effect could create dramatic selloffs in underlying securities just as cascading demand seems to drive price increases on the way up
  10. The Robo-Adviser, Part II: What’s in Your Asset Allocation Program?; robo-advisor portfolio recommendations seem to make similar investment allocations despite different inputs, creating a herd momentum in index ETFs
  11. How Indexation is Creating New Opportunities for Short-Sellers, And Why This Should Alarm Ordinary Buyers of Stock and Bond ETFs; historically low interest rates and growth of indexing as a strategy have made short-selling a punishing exercise, but sudden and unpredictable price volatility will force low-beta ETFs to dump their holdings in favor of other securities, opening up opportunities for short-sellers to profit
  12. Why Utility Stocks Should Concern Income-Oriented Investors; qualitative analysis reveals a worrisome risk picture for the utility industry, yet ETF flows and the search for yield have combined to create high P/Es for the industry as a whole
  13. The Exxon Conundrum; despite a massive decrease in the price of oil and thus $XOM’s per share earnings, its share price was relatively unimpacted and it remains an overweight position of numerous ETFs, suggesting it is $XOMs pre-existing size and liquidity which generates its (over-)valuation, and not the other way around
  14. 5000 Years of Interest Rates (Part I); interest rates in 5,000 years of recorded human history across the globe have never been near zero or negative as they predominantly are in Western economies at present, meaning equity valuations are built on truly unprecedented circumstances while most financial logic involves historical pricing as a basis constructing behavioral models
  15. 5000 Years of Interest Rates (Part II); interest rate increases would result in painful adjustments to the value of fixed-income (bonds) and fixed income-like ETFs (REITs, utilities), and a safer bet would be in non-indexed securities whose prices are already somewhat depressed and whose underlying businesses represent idiosyncratic risks versus the broad market
  16. What’s in Your Index? The Value of Cash; cash is deemed to be a liability in a low interest rate environment, creating a drive to acquire assets regardless of valuation, when in reality cash might be the very thing investors need to survive the coming tide of rising rate-induced market crashes
  17. What’s in Your Index? Gold Miner ETFs; leveraged ETFs in the gold miner space seem to be creating price movements divorced from the underlying fundamentals of gold itself, indicating this is not an efficient market despite the fact that it is being indexed (or rather, because it is being indexed)
  18. The Indexation That Is, Versus The Indexation That Should Be; the commodity nature of index strategies implies that most fund providers who face the same profit motives as active managers of the past will promote diversification strategies to “index investors” that will cause them to underperform the broad market for the same reasons active managers did

The Argument (So Far), Summarized:

  •  Modern indexation is primarily practiced via allocation to various thematic ETFs
  • The construction of the thematic ETFs is often inconsistent with their stated theme and therefore unable to provide the sought after diversification, due to liquidity constraints
  • The price behavior and valuation of the holdings within these ETFs seem divorced from underlying economic reality and are largely explainable through the feedback mechanism of high inflows to indexation/ETF-based strategies themselves
  • Myopic focus on beta (a measure of relative volatility) and momentum (tendency for price trend to continue, a characteristic which shouldn’t exist in an efficient market) have created herd mentalities and currently dominate index-driven strategies
  • Indexation as a strategy requires and logically replies upon historical price data, but the data being relied upon was gathered in an interest rate environment that was historically normal but entirely dissimilar to recent interest rate paradigms, bringing into question the validity of this data to present strategies
  • Indexation relies upon the existence of an efficient market to operate, but the indexation phenomenon itself seems to be driving persistent inefficiencies in the market, bringing into question the stability of the indexation phenomenon
  • Most current index investors do not follow the historic and academic recommendations for executing an index strategy, nor can they given the profit motives of investment marketers offering ETFs outside of the broad market index theme, ensuring underperformance relative to the index benchmark for the same reasons active managers underperformed in the past

BONUS, Horizon Kinetics Q4 2016 Market Commentary, summarized:

  • When the total available pool of index-driven funds reaches its limit, index strategies which are valuation-neutral will no longer set the marginal price for the underlying securities they own, and that price will be set by value-conscious active managers, implying a sharp correction downward for indexed security prices in general
  • Indexation as a strategy has a place in certain portfolios in a “normal market”, but this is not that market and therefore indexation seems to carry undue risk
  • There is no such thing as an “inadequate index return”, so index investors have no logical basis for being unhappy with the returns they get
  • If index investors did try to pull their money all at once, there is no logical alternative to active asset managers because bonds are priced too high to offer a greater return and there is not enough money in money market funds to change places with the index fund outflows at current prices
  • Returns to large cap equities from 1926-2015 have averaged between 9% and 10% a year; returns to equities from 1824-1924 averaged 7% a year, but most of that return came in the form of dividends, not price appreciation
  • In an age of indexation, true diversification comes from analyzing individual securities and finding the one’s whose share price performance is not dictated by broader market trends, as indexed ETF securities are
  • The age of analyst-driven active management may again be upon us

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