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Why owning the market doesn't always pay

Glenn Freeman  |  30 Aug 2017Text size  Decrease  Increase  |  
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We look at some compelling counter-arguments to index investing posed by Platinum's Kerr Neilson and Morningstar's John Rekenthaler.


Drawing together threads from modern portfolio theory and the capital asset pricing model, Rekenthaler, vice president of research, Morningstar Inc, weaves these with some more humanistic elements, in a recent article written for Morningstar in the US.

He believes the concept that rational investors should own all equities, "in proportion to their stock-market worth, relies on the assumption that stock owners will routinely leverage at the risk-free rate".

"As that is not the case, the theory collapses. There may be valid grounds to own something other than the market portfolio," Rekenthaler says.

Harry M. Markowitz is widely regarded as the father of modern portfolio theory, which he pioneered in his 1952 research paper, "Portfolio Selection". This relates to the way risk-averse investors can construct portfolios to optimise or maximise expected return based on a given level of market risk.

A core part of this is the inherent correlation between risk and reward. Markowitz's theory posits that it's possible to construct an "efficient frontier" of optimal portfolios that offer maximum reward for a given risk level.

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In this context, Rekenthaler also references the capital asset pricing model (CAPM), which describes the relationship between systematic risk and expected return for assets, particularly stocks. CAPM is widely used within the financial sector for pricing securities that are regarded as risky, and for generating expected returns in line with these risks and capital costs.

"If too much money chases the same sub-group of high-beta stocks, then those securities may become overbought, and thus deliver weaker-than-expected future returns. Then, as the news of that failure becomes known, investors might flee high-beta stocks, knocking down their prices so that they become bargains," Rekenthaler says.

"Because the stock market does not obey one of CAPM's key assumptions, it may have systematic pricing distortions. That represents an opportunity for active investment managers."

He suggests other things may also cause "knock-on effects". For instance, the potential distortionary effect of outsized inflows into ETFs, particularly those stocks that are held by "the popular indexes" and which leave "other shares to languish".

Behavioural aspects

Outside of pricing-related concerns, he relays some more normative arguments against indexing. These centre on the infinite number of variables in individual investors' personal circumstances, and everyone's differing levels of human capital.

"Individual circumstances can lead two fully rational investors to hold different stock portfolios," Rekenthaler says. "Varying demand for liquidity among different investors is one obvious example."

"An investment manager who runs a mutual fund that has few shareholders, with each shareholder commanding a high percentage of fund assets, faces the daily possibility of being forced to sell a big chunk of assets to meet a sudden redemption.

"In contrast, the investment manager of a closed-end fund faces no such danger."

Following the same line of reasoning, individual companies have distinct levels of economic sensitivity.

"This attribute leads to these stocks being priced somewhat lower than they otherwise would be, thereby suggesting that they have higher expected returns. Those who can better withstand investment losses during recessions may tilt toward such stocks, while those in the opposite position will not," he says.

John Rekenthaler will be in Australia in October as a keynote presenter at the Morningstar Individual Investor Conference 2017.

Aussies love imputations

In a more localised context, Kerr Neilson, managing director, Platinum Asset Management, says Australian investors' love affair with franking credits is overdone.

"Franking credits loom large in mind, but small in fact," Neilson said recently, during a webcast interview with Morningstar's director of manager of research, Tim Murphy.

He believes there is an "overstatement of the benefit" of franking credits among equities investors, who are overly concentrated in domestic stocks, "which misses the opportunity in international shares".

Neilson introduces a different slant on the human capital argument mentioned by Rekenthaler, in terms of the additional element of diversification risk. While many Australian investors seem to believe that having 15 per cent of their total portfolio invested abroad provides enough diversity, he believes this is not the case.

This is because their primary incomes are derived from Australian jobs, and their investments are also primarily domestically-based.

Applying this to Platinum's approach, he says it looks for tangential opportunities, but not always. For instance, he refers to Platinum's investment in one of the most well-known technology stocks, Google--but says they got in before it was such a crowded trade, entering "when everyone was worried about the risks from internet search".

On a macro level, Neilson repeatedly emphasises the need for investors not to equate an index's performance with the true diversity of its various constituents--essentially, reminding us that the whole is more than the sum of its parts.

A key message is that investors need to think about the constituents of an index. Looking at the Morgan Stanley Capital Index (MSCI)--one of the most commonly cited global indexes--Neilson says, "If you look at which markets go well from one year to the next, you could use a dartboard to try and forecast".

"Over the last four years, the roulette wheel has landed on red--America--which is very unusual," he says. "We suggest that the long bull market has principally been in the US, not in Japan, China ... nor has it been as broad-based as the MSCI would suggest."

"Look at individual markets rather than the index ... People need to think more broadly about an index not representing the world's activity."

More from Morningstar

3 large-cap stocks in energy and infrastructure

Grey rhinos, fierce competition confront foreign markets

• Hear more from John Rekenthaler at Morningstar Individual Investor Conference 2017


Glenn Freeman is a senior editor at Morningstar.

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