Passive Aggressive
A defence of active investing and two examples of passive distortions: a Vietnamese ETF and a gold-mining ETF
This Insight is not investment advice and should not be construed as such. Past performance is not predictive of future results. Fund(s) managed by Seraya Investment may be long or short securities mentioned in this Insight. Any resemblance of people or companies mentioned in this Insight to real entities is purely coincidental. Our full Disclaimer can be found here.
This Insight is an extract adapted from the Panah Fund letter to investors for Q2 2017.1
TABLE OF CONTENTS
In recent years, the popular press has been keen to talk down actively-managed funds.2 The gist of their criticism has been that few active funds have outperformed their benchmarks, and fund managers have enriched themselves at the expense of clients.
Luminaries such as Saint Warren of Omaha have also preached the gospel on the ‘democratisation of investment’, sanctifying the trend towards investing in low-fee funds.3
The rush towards passive investment has been further facilitated by the spread of technology and the rise of the Exchange-Traded Fund (‘ETF’).4 At end-April 2017, it was estimated that the global ETF industry managed a total US ~$4tn of assets - a doubling in assets since the end of 20125 even as active managers have seen outflows.
Here at Panah, we are the first to point the finger (and throw tomatoes) at ‘closet index funds’ which pretend to pick stocks but then track their chosen indices on the sly with minimal deviation. Such funds will almost certainly underperform after fees.6 We also recognise the benefits of giving investors low-cost access to equities, and of cutting unnecessary fees within the investment industry.
The argument against active investing, however, is not as clear-cut as the media hype would have everyone believe. While newspapers might suggest that passive always outperforms, in reality, studies comparing active and passive investment strategies have not yielded uniform conclusions.7 Management fees pay for research, and while it might be hard for stock-pickers to add value when analysing US large cap stocks, it should be possible for active managers to outperform in more inefficient markets.8
The systemic implications of the rise of passive investment are also important. Fewer active funds mean less analysts and fund managers left to do the fundamental work of stock-picking. The participation of such market players is vital as they help determine – by virtue of analysing stocks, then deploying capital to buy the best and sell the worst – which companies are worthy of being included in an index, and which are the duds.9
It would not be an exaggeration to say that passive investment ‘freerides’ on the hard work performed by active managers. The investment world would be a sorry place if active funds were pushed to the brink of extinction, as from an economic perspective they are engaged in the essential work of attempting to allocate capital efficiently. If investors in aggregate are only willing to pay peanuts to allocate capital, then over time we will get the capital markets we deserve.
From our vantage point at the coalface of active management (which offers occasional rather than comprehensive insights into passive investment), we will share a couple of recent examples which serve to illustrate the unintended consequences of passive investment.
Why Vietnamese ETFs Don’t Work
The first example involves Vietnam, which is a problematic market when it comes to tracking an index. The dominant Vietnamese ETFs10 cannot replicate the major local stock indices because of the existence of Foreign Ownership Limits (FOLs) on most local companies.11 Instead, they are restricted to buying stocks with a low foreign ownership ratio. These are usually the companies which have been shunned by the active stock-pickers for one reason or another (e.g., corporate governance, poor prospects). It is thus unsurprising that such Vietnam ETFs have substantially lagged the VNIndex since inception.
The recent emergence of Vietnam index heavy-weight FLC Faros Construction (‘Faros’) from obscurity offers a cautionary tale. This company, which is the Hanoi-based construction arm of real estate developer FLC (both controlled by the same tycoon), quietly listed in Ho Chi Minh in September 2016. Over the next seven months, the share price rocketed upwards by ~2,000%, pushing the company’s market cap to as much as US ~$2.6bn!
By this stage, Faros had already become the seventh largest stock in the VNIndex, trading on a trailing P/E ratio of >150x with barely any cash flow. Moreover, few brokers or analysts whom we approached appeared to know much about the company’s business activities. Meanwhile, rumours swirled about the company and its rise to prominence; a limited free float (of ~27%) was said to have made it easier to manipulate the stock price.12
Despite the concerns, Faros was a new ‘liquid’ Vietnamese large cap, and so by late June 2017 both major ETFs had added Faros as a major holding, with weightings close to 5%. At least these ETFs did not dive quite in at the top, as the Faros share price had by then already fallen ~50% from the March peak to mid-June, and was trading at the more ‘modest’ valuation multiple of 85x last year’s earnings.
So, while ETFs might seem like the cheapest and easiest way to ‘access a market’, complications can emerge in different countries for unexpected reasons. Investors would be well-advised to take a closer look at an ETF’s largest underlying holdings before deciding to invest.
Gold ETF Distortions
Switching tack, we have noticed that when one or two ETFs come to dominate a market niche, there is a risk that the tail starts to wag the dog. This seems to be what has happened over the last 18 months in the listed gold mining sector, as result of the sudden popularity of the Van Eck Vectors Gold Miners ETFs (popularly known by their stock tickers GDX and GDXJ).
The gold price spike in H1 2016 caused a large increase in investment interest in the Junior Gold Miners ETF (‘GDXJ’). Net assets increased from US ~$1bn at the start of 2016 to almost $5bn by September. This sudden increase caused challenges – by the third quarter of the year, GDXJ already owned the maximum permissible stake in various Canadian junior gold mining stocks.13
At this juncture, an open-ended fund might well have decided to limit inflows, to avoid a scenario where the fund had more capital than it could deploy in its chosen strategy. GDXJ, however, still wanted to expand and so started to buy shares in its bigger brother GDX (which invests in larger and more mature gold-mining stocks). By end-Q3 2016, GDX had become the third largest holding in GDXJ!14
By April 2017, the problem had still not gone away, and so Van Eck announced a massive rebalance of the index tracked by the GDXJ, purging smaller gold stocks to replace them with larger and more established gold-mining companies.
The index rebalance date was set for mid-June, two months later. The markets quickly worked out that the implied selling pressure on some smaller stocks was equivalent to more than two weeks of total trading volume. Investors thus front-ran the rebalance, dumping the stocks which were likely to see the biggest impact from ETF down-weightings and deletions.
As a result, the share prices of some firm fell by some -30-60% over the following six weeks! This was almost all due to flows, with little reference to company fundamentals. Some active investors were able to pick up bargains as a result of the indiscriminate ETF deletions, although the performance of the ETF and its investors suffered.
While this rebalance has enabled Van Eck to continue growing the assets of its ‘junior gold miners ETF’, GDXJ no longer exclusively focuses on junior gold miners. As more money flows towards a few large ETFs in the sector, and as these ETFs focus on the larger gold-miners, the smaller gold companies will likely find it harder to get funding and develop gold mines.
As passive interest in other sectors outstrips active involvement, one should probably expect the inefficiencies to multiply. We would not be surprised to see other similar examples in the future. As inefficiencies increase, however, this should create an opportunity for investors to generate alpha – if there are any active managers left by then!
Eventually, the asset allocation pendulum might start to swing back from passive to active, although we do not appear to be at this juncture yet. Calling time on this particular cycle is somewhat tricky.
Thank you for reading.
Andrew Limond
The original source material has been edited for spelling, punctuation, grammar and clarity. Photographs, illustrations, diagrams and references have been updated to ensure relevance. Copies of the original quarterly letter source material are available to investors on request.
Active managers charge clients fees to pick stocks in an attempt to outperform a specified benchmark or make absolute returns.
In the 2016 Berkshire Hathaway annual letter to shareholders, Buffett wrote: “When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds.”
An Exchange-Traded Fund is a pooled investment fund which can be traded on an exchange just like a stock.
These statistics are as reported by ETFGI. This compares to mutual funds which managed an estimated total ~$16.3bn in assets at end-2016.
Panah is an absolute return fund. We seek to make positive returns in a conservative manner rather than to beat a specified benchmark. As one might expect, a comparison of Panah’s positions at end-June 2017 relative to various popular regional benchmarks reveals an overlap of just a few percent.
Part of the challenge is that there are strong vested interests on both sides of the debate, with much to win or lose.
We would expect active management to be able to outperform in more inefficient markets such as small caps and Emerging Markets. For more information on inefficiencies in Asian markets, see the Panah Fund letter to investors for Q 20 and the following Seraya Insight: ‘Why Asia's Market Inefficiencies = Opportunities’.
Most (although not all) important indices rank stocks for inclusion based on their market capitalisation.
The largest ETFs which seek to invest primarily in Vietnamese equities are the VanEck Vectors Vietnam ETF and the db x-trackers FTSE Vietnam UCITS ETF.
These FOLs are in the process of being removed, but so far fairly slowly, and on a stock-by-stock basis.
There was widespread confusion over what might be causing the share price move, although Vietnamese blogs reported various allegations. There have also been several cases of alleged share price manipulation in Hong Kong in recent years, especially in stocks with a limited free float and a ‘motivated’ dominant shareholder; the best-known example is probably Hanergy.
More than 50% of the fund’s holdings are listed in Canada, and Canadian listing regulations dictate that if any shareholder’s stake in a listed company rises to 20% or more, this shareholder must make a general offer.
